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 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. As with many other companies Lovisa Holdings Limited (ASX:LOV) makes use of debt. But should shareholders be worried about its use of debt?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Lovisa Holdings's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Lovisa Holdings had AU$7.99m of debt, an increase on none, over one year. But it also has AU$20.3m in cash to offset that, meaning it has AU$12.3m net cash.
How Strong Is Lovisa Holdings's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Lovisa Holdings had liabilities of AU$38.1m due within 12 months and liabilities of AU$7.45m due beyond that. Offsetting these obligations, it had cash of AU$20.3m as well as receivables valued at AU$3.24m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$22.0m.
This state of affairs indicates that Lovisa Holdings's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the AU$1.28b company is struggling for cash, we still think it's worth monitoring its balance sheet. While it does have liabilities worth noting, Lovisa Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.
The good news is that Lovisa Holdings has increased its EBIT by 2.7% over twelve months, which should ease any concerns about debt repayment. 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 Lovisa Holdings 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Lovisa Holdings has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Lovisa Holdings recorded free cash flow worth 58% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Lovisa Holdings has AU$12.3m in net cash. So is Lovisa Holdings's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Lovisa Holdings is showing 2 warning signs in our investment analysis , and 1 of those can't be ignored...
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.
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.
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