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.' 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 Livent Corporation (NYSE:LTHM) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Livent Carry?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Livent had US$50.0m of debt, an increase on none, over one year. However, it does have US$17.8m in cash offsetting this, leading to net debt of about US$32.2m.
How Healthy Is Livent's Balance Sheet?
According to the last reported balance sheet, Livent had liabilities of US$79.1m due within 12 months, and liabilities of US$84.1m due beyond 12 months. On the other hand, it had cash of US$17.8m and US$137.3m worth of receivables due within a year. So it has liabilities totalling US$8.10m more than its cash and near-term receivables, combined.
Having regard to Livent's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the US$973.8m company is struggling for cash, we still think it's worth monitoring its balance sheet.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Livent's net debt is only 0.20 times its EBITDA. And its EBIT easily covers its interest expense, being 485 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Livent grew its EBIT by 8.9% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Livent 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Livent reported free cash flow worth 6.6% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Livent's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. Looking at all the aforementioned factors together, it strikes us that Livent can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Livent insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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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