U.S. Markets closed

Lenovo Group (HKG:992) Takes On Some Risk With Its Use Of Debt

Simply Wall St

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Lenovo Group Limited (HKG:992) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Lenovo Group

How Much Debt Does Lenovo Group Carry?

The image below, which you can click on for greater detail, shows that at June 2019 Lenovo Group had debt of US$4.91b, up from US$4.48b in one year. However, because it has a cash reserve of US$2.80b, its net debt is less, at about US$2.10b.

SEHK:992 Historical Debt, September 9th 2019

How Strong Is Lenovo Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Lenovo Group had liabilities of US$22.8b due within 12 months and liabilities of US$5.31b due beyond that. Offsetting this, it had US$2.80b in cash and US$11.5b in receivables that were due within 12 months. So its liabilities total US$13.9b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$8.40b 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, Lenovo Group would probably need a major re-capitalization if its creditors were to demand repayment.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Looking at its net debt to EBITDA of 1.1 and interest cover of 5.7 times, it seems to us that Lenovo Group is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, Lenovo Group grew its EBIT by 36% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Lenovo Group 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Lenovo Group recorded free cash flow of 24% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Lenovo Group's level of total liabilities was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Lenovo Group's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Given our hesitation about the stock, it would be good to know if Lenovo Group insiders have sold any shares recently. You click here to find out if insiders have sold recently.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.