David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Lumber Liquidators Holdings, Inc. (NYSE:LL) makes use of debt. But the more important question is: how much risk is that debt creating?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Lumber Liquidators Holdings's Debt?
As you can see below, at the end of March 2019, Lumber Liquidators Holdings had US$67.0m of debt, up from US$26.0m a year ago. Click the image for more detail. On the flip side, it has US$17.1m in cash leading to net debt of about US$49.9m.
A Look At Lumber Liquidators Holdings's Liabilities
Zooming in on the latest balance sheet data, we can see that Lumber Liquidators Holdings had liabilities of US$264.1m due within 12 months and liabilities of US$169.0m due beyond that. Offsetting this, it had US$17.1m in cash and US$2.80m in receivables that were due within 12 months. So it has liabilities totalling US$413.2m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of US$290.9m, we think shareholders really should watch Lumber Liquidators Holdings's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Lumber Liquidators Holdings has a low net debt to EBITDA ratio of only 1.3. And its EBIT covers its interest expense a whopping 14.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that Lumber Liquidators Holdings grew its EBIT at 19% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Lumber Liquidators Holdings's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last two years, Lumber Liquidators Holdings's free cash flow amounted to 24% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Lumber Liquidators Holdings's level of total liabilities and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Lumber Liquidators Holdings's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. While Lumber Liquidators Holdings didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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