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.' 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. We note that LSL Property Services plc (LON:LSL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is LSL Property Services's Net Debt?
As you can see below, at the end of December 2018, LSL Property Services had UK£51.6m of debt, up from UK£41.1m a year ago. Click the image for more detail. However, because it has a cash reserve of UK£2.41m, its net debt is less, at about UK£49.2m.
A Look At LSL Property Services's Liabilities
Zooming in on the latest balance sheet data, we can see that LSL Property Services had liabilities of UK£83.7m due within 12 months and liabilities of UK£49.3m due beyond that. Offsetting this, it had UK£2.41m in cash and UK£25.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£105.6m.
While this might seem like a lot, it is not so bad since LSL Property Services has a market capitalization of UK£210.0m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
LSL Property Services's net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 22.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that LSL Property Services saw its EBIT decline by 3.4% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine LSL Property Services'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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, LSL Property Services produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
When it comes to the balance sheet, the standout positive for LSL Property Services was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. For example, its EBIT growth rate makes us a little nervous about its debt. Considering this range of data points, we think LSL Property Services is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. We'd be motivated to research the stock further if we found out that LSL Property Services insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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