These 4 Measures Indicate That Lookers (LON:LOOK) Is Using Debt In A Risky Way
Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Lookers plc (LON:LOOK) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
See our latest analysis for Lookers
What Is Lookers's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Lookers had debt of UK£192.7m, up from UK£127.5m in one year. However, because it has a cash reserve of UK£93.6m, its net debt is less, at about UK£99.1m.
A Look At Lookers's Liabilities
The latest balance sheet data shows that Lookers had liabilities of UK£1.37b due within a year, and liabilities of UK£382.8m falling due after that. Offsetting these obligations, it had cash of UK£93.6m as well as receivables valued at UK£302.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£1.35b.
This deficit casts a shadow over the UK£216.0m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt At the end of the day, Lookers would probably need a major re-capitalization if its creditors were to demand repayment.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
While Lookers's low debt to EBITDA ratio of 1.4 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.7 last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, Lookers's EBIT fell a jaw-dropping 24% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Lookers's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Lookers reported free cash flow worth 7.6% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Our View
On the face of it, Lookers's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at managing its debt, based on its EBITDA,; that's encouraging. After considering the datapoints discussed, we think Lookers has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given the risks around Lookers's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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