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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Lions Gate Entertainment Corp. (NYSE:LGF.A) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Lions Gate Entertainment Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Lions Gate Entertainment had US$3.11b of debt, an increase on US$2.50b, over one year. However, because it has a cash reserve of US$196.0m, its net debt is less, at about US$2.91b.
How Healthy Is Lions Gate Entertainment's Balance Sheet?
The latest balance sheet data shows that Lions Gate Entertainment had liabilities of US$1.70b due within a year, and liabilities of US$3.75b falling due after that. Offsetting these obligations, it had cash of US$196.0m as well as receivables valued at US$802.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.45b.
This deficit casts a shadow over the US$2.33b 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, Lions Gate Entertainment 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Weak interest cover of 0.98 times and a disturbingly high net debt to EBITDA ratio of 8.4 hit our confidence in Lions Gate Entertainment like a one-two punch to the gut. The debt burden here is substantial. Even worse, Lions Gate Entertainment saw its EBIT tank 38% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that 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 Lions Gate Entertainment can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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, Lions Gate Entertainment actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
On the face of it, Lions Gate Entertainment'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 on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Lions Gate Entertainment 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 Lions Gate Entertainment's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.