The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Lynch Group Holdings Limited (ASX:LGL) makes use of debt. But the real question is whether this debt is making the company risky.
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.
View our latest analysis for Lynch Group Holdings
As you can see below, Lynch Group Holdings had AU$55.1m of debt, at June 2024, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of AU$32.3m, its net debt is less, at about AU$22.7m.
Zooming in on the latest balance sheet data, we can see that Lynch Group Holdings had liabilities of AU$62.1m due within 12 months and liabilities of AU$95.2m due beyond that. Offsetting this, it had AU$32.3m in cash and AU$19.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$105.0m.
This deficit isn't so bad because Lynch Group Holdings is worth AU$203.2m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
Lynch Group Holdings has a very low debt to EBITDA ratio of 0.69 so it is strange to see weak interest coverage, with last year's EBIT being only 2.3 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Unfortunately, Lynch Group Holdings's EBIT flopped 19% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 Lynch Group 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Lynch Group 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.
Both Lynch Group Holdings's EBIT growth rate and its interest cover were discouraging. But on the brighter side of life, its net debt to EBITDA leaves us feeling more frolicsome. When we consider all the factors discussed, it seems to us that Lynch Group Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with Lynch Group Holdings .
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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.