Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Louisiana-Pacific Corporation (NYSE:LPX) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Louisiana-Pacific’s Net Debt?
As you can see below, Louisiana-Pacific had US$346.0m of debt, at June 2021, which is about the same as the year before. You can click the chart for greater detail. But on the other hand it also has US$590.0m in cash, leading to a US$244.0m net cash position.
How Healthy Is Louisiana-Pacific’s Balance Sheet?
We can see from the most recent balance sheet that Louisiana-Pacific had liabilities of US$353.0m falling due within a year, and liabilities of US$572.0m due beyond that. Offsetting this, it had US$590.0m in cash and US$310.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$25.0m.
This state of affairs indicates that Louisiana-Pacific’s balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it’s very unlikely that the US$6.18b company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, Louisiana-Pacific boasts net cash, so it’s fair to say it does not have a heavy debt load!
Even more impressive was the fact that Louisiana-Pacific grew its EBIT by 989% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Louisiana-Pacific can strengthen its balance sheet over time.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Louisiana-Pacific may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Louisiana-Pacific recorded free cash flow worth 70% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to look at a company’s total liabilities, it is very reassuring that Louisiana-Pacific has US$244.0m in net cash. And we liked the look of last year’s 989% year-on-year EBIT growth. So we don’t think Louisiana-Pacific’s use of debt is risky. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet.