Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 note that Leonardo S.p.a. (BIT:LDO) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Leonardo's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Leonardo had €5.44b of debt, an increase on €4.65b, over one year. However, it also had €1.18b in cash, and so its net debt is €4.26b.
How Strong Is Leonardo's Balance Sheet?
We can see from the most recent balance sheet that Leonardo had liabilities of €15.1b falling due within a year, and liabilities of €6.54b due beyond that. On the other hand, it had cash of €1.18b and €6.58b worth of receivables due within a year. So it has liabilities totalling €13.9b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the €6.44b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt After all, Leonardo would likely require a major re-capitalisation if it had to pay its creditors today.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Leonardo's debt is 2.9 times its EBITDA, and its EBIT cover its interest expense 5.9 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. It is well worth noting that Leonardo's EBIT shot up like bamboo after rain, gaining 38% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Leonardo 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Leonardo's free cash flow amounted to 23% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Mulling over Leonardo's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Leonardo'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 Leonardo, you may well want to click here to check an interactive graph of its earnings per share history.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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