Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We note that LCI Industries (NYSE:LCII) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does LCI Industries Carry?
The chart below, which you can click on for greater detail, shows that LCI Industries had US$793.8m in debt in March 2021; about the same as the year before. However, it also had US$63.3m in cash, and so its net debt is US$730.4m.
A Look At LCI Industries’ Liabilities
We can see from the most recent balance sheet that LCI Industries had liabilities of US$535.0m falling due within a year, and liabilities of US$1.01b due beyond that. Offsetting these obligations, it had cash of US$63.3m as well as receivables valued at US$405.4m due within 12 months. So it has liabilities totalling US$1.07b more than its cash and near-term receivables, combined.
This deficit isn’t so bad because LCI Industries is worth US$3.48b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
We’d say that LCI Industries’s moderate net debt to EBITDA ratio ( being 1.9), indicates prudence when it comes to debt. And its strong interest cover of 25.5 times, makes us even more comfortable. Importantly, LCI Industries grew its EBIT by 39% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if LCI Industries 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, LCI Industries produced sturdy free cash flow equating to 66% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
LCI Industries’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And the good news does not stop there, as its EBIT growth rate also supports that impression! Zooming out, LCI Industries seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it.