Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Lydall, Inc. (NYSE:LDL) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.
What Is Lydall's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Lydall had debt of US$299.6m, up from US$77.1m in one year. However, it does have US$43.4m in cash offsetting this, leading to net debt of about US$256.1m.
How Strong Is Lydall's Balance Sheet?
The latest balance sheet data shows that Lydall had liabilities of US$131.9m due within a year, and liabilities of US$377.5m falling due after that. Offsetting this, it had US$43.4m in cash and US$171.7m in receivables that were due within 12 months. So it has liabilities totalling US$294.2m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$358.8m. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Lydall has a debt to EBITDA ratio of 2.7 and its EBIT covered its interest expense 4.3 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Another concern for investors might be that Lydall's EBIT fell 12% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Lydall can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Lydall's free cash flow amounted to 49% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
To be frank both Lydall's level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. Once we consider all the factors above, together, it seems to us that Lydall's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. Over time, share prices tend to follow earnings per share, so if you're interested in Lydall, you may well want to click here to check an interactive graph of its earnings per share history.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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