Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We can see that LOTOS Group SA (WSE:LTS) uses debt in its operations. But the real question is whether this debt makes the business risky.
What risk does debt carry?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. 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 look at debt levels, we first consider cash and debt levels, together.
Check out our latest analysis for Grupa LOTOS
What is Grupa LOTOS’ net debt?
The image below, which you can click on for more details, shows that in March 2022, Grupa LOTOS had a debt of 3.69 billion zł, compared to 3.41 billion zł in one year. On the other hand, it has 2.11 billion zł of liquid assets, which results in a net debt of approximately 1.57 billion zł.
How healthy is Grupa LOTOS’ balance sheet?
We can see from the most recent balance sheet that Grupa LOTOS had liabilities of 7.77 billion zł maturing in one year, and liabilities of 4.99 billion zł beyond. As compensation for these obligations, it had cash of 2.11 billion zł as well as receivables valued at 3.02 billion zł, payable within 12 months. Thus, its liabilities total 7.62 billion zł more than the combination of its cash and short-term receivables.
This deficit is considerable compared to its market capitalization of 12.6 billion zł, so it suggests that shareholders monitor the use of debt by Grupa LOTOS. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant 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 ).
Grupa LOTOS’ net debt is only 0.24 times its EBITDA. And its EBIT covers its interest charges 104 times. So we’re pretty relaxed about his super conservative use of debt. What is even more impressive is that Grupa LOTOS increased its EBIT by 1,548% year-over-year. If sustained, this growth will make debt even more manageable in years to come. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Grupa LOTOS can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. It is therefore worth checking how much of this EBIT is supported by free cash flow. Over the past three years, Grupa LOTOS has produced strong free cash flow equivalent to 60% of its EBIT, which is what we expected. This cold hard cash allows him to reduce his debt whenever he wants.
Our point of view
The good news is that Grupa LOTOS’ demonstrated ability to cover its interest charges with its EBIT delights us like a fluffy puppy does a toddler. But truth be told, we think his total passive level undermines that impression a bit. Given all this data, it seems to us that Grupa LOTOS is taking a pretty sensible approach to debt. This means they take on a bit more risk, hoping to increase shareholder returns. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. Know that Grupa LOTOS shows 2 warning signs in our investment analysis and 1 of them is significant…
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% freeright now.
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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.