Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We can see that Liberty Shoes Ltd. (NSE:LIBERTSHOE) uses debt in its business. But the real question is whether this debt makes the business risky.
What risk does debt carry?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. If things go really bad, lenders can take over the business. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for Liberty Shoes
How much debt do Liberty shoes carry?
As you can see below, Liberty Shoes had a debt of ₹896.8 million as of September 2021, up from ₹1.21 billion the previous year. On the other hand, he has ₹38.8 million in cash, resulting in a net debt of around ₹857.9 million.
How healthy is Liberty Shoes’ balance sheet?
According to the latest published balance sheet, Liberty Shoes had liabilities of ₹1.66 billion due within 12 months and liabilities of ₹978.9 million due beyond 12 months. As compensation for these obligations, it had cash of ₹38.8 million as well as receivables valued at ₹1.17 billion due within 12 months. It therefore has liabilities totaling ₹1.44 billion more than its cash and short-term receivables, combined.
This shortfall is not that bad as Liberty Shoes is worth ₹2.65 billion and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. But it is clear that it must be carefully examined whether he can manage his debt without dilution.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Given that net debt is only 1.5 times EBITDA, it is initially surprising to see that Liberty Shoes’ EBIT has a low interest coverage of 2.2 times. So, even if we are not necessarily alarmed, we think that his debt is far from trivial. Notably, Liberty Shoes’ EBIT launched higher than Elon Musk, gaining a whopping 252% over last year. When analyzing debt levels, the balance sheet is the obvious starting point. But it is the profits of Liberty Shoes that will influence the balance sheet in the future. So, if you want to know more about its earnings, it might be worth checking out this graph of its long-term trend.
Finally, a company can only repay its debts with cold hard cash, not with book profits. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Liberty Shoes has recorded free cash flow of 75% of its EBIT, which is about normal given that free cash flow excludes interest and taxes. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
Liberty Shoes’ EBIT growth rate suggests it can manage its debt as easily as Cristiano Ronaldo could score a goal against an Under-14 keeper. But the hard truth is that we are concerned about his coverage of interests. Looking at all of the aforementioned factors together, it seems to us that Liberty Shoes can manage its debt quite comfortably. Of course, while this leverage can improve return on equity, it comes with more risk, so it’s worth keeping an eye out for. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 3 warning signs for Liberty Shoes (2 of which are a bit of a concern!) that you should know about.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.