Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. Above all, Leonardo Spa (BIT: LDO) carries a debt. But should shareholders be concerned about its use of debt?
What risk does debt entail?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, many companies use debt to finance their growth without negative consequences. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
Check out our latest analysis for Leonardo
What is Leonardo’s debt?
The image below, which you can click for more details, shows Leonardo had a debt of 4.56 billion euros at the end of June 2021, a reduction from 5.21 billion euros over one year . However, because it has a cash reserve of € 387.0 million, its net debt is lower, at around € 4.17 billion.
How strong is Leonardo’s balance sheet?
The latest balance sheet data shows Leonardo had liabilities of € 14.8 billion maturing within one year, and liabilities of € 5.52 billion maturing thereafter. On the other hand, it had cash of € 387.0 million and € 7.12 billion in receivables within one year. It therefore has liabilities totaling 12.8 billion euros more than its combined cash and short-term receivables.
The lack here weighs heavily on the € 4.11 billion company itself, as if a child struggles under the weight of a huge backpack full of books, his gym equipment and a trumpet. We would therefore be watching its record closely, without a doubt. Ultimately, Leonardo would likely need a major recapitalization if his creditors demanded repayment.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Leonardo has a net debt to EBITDA of 2.5, which suggests that he uses good leverage to increase returns. But the high interest coverage of 8.2 suggests he can easily pay off that debt. We note that Leonardo has increased his EBIT by 30% over the past year, which should make it easier to repay debt in the future. The balance sheet is clearly the area you need to focus on when analyzing debt. But it’s future profits, more than anything, that will determine Leonardo’s ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business can only repay its debts with hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Looking at the past three years, Leonardo has actually experienced an overall cash outflow. Debt is much riskier for companies with unreliable free cash flow, so shareholders should hope that past spending will produce free cash flow in the future.
Our point of view
At first glance, Leonardo’s conversion of EBIT to free cash flow left us hesitant about the stock, and his total liability level was no more appealing than the single empty restaurant on the busiest night of the year. year. But on the positive side, its EBIT growth rate is a good sign and makes us more optimistic. Overall, we think it’s fair to say that Leonardo has enough debt that there is real risk around the balance sheet. If all goes well, this should increase returns, but on the other hand, the risk of permanent capital loss is increased by debt. The balance sheet is clearly the area you need to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we discovered 3 warning signs for Leonardo which you should know before investing here.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page. free list of growing companies that have net cash on the balance sheet.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in any of the stocks mentioned.
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