Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. When we think about how risky a business is, we always like to look at its use of debt because debt overload can lead to bankruptcy. We note that Larsen & Toubro Limited (NSE: LT) has debt on its balance sheet. But the real question is whether this debt makes the business risky.
When Is Debt a Problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. When we look at debt levels, we first consider both cash and debt levels.
Check out our latest analysis for Larsen & Toubro
What is the debt of Larsen and Toubro?
The image below, which you can click for more details, shows that Larsen & Toubro had a debt of 1.35 t at the end of March 2021, a reduction from 1.43 t over one year. However, he also had 450.0 billion yen in cash, so his net debt is 896.3 billion yen.
A look at the responsibilities of Larsen & Toubro
Zooming in on the latest balance sheet data, we can see that Larsen & Toubro had liabilities of 1.37 t due within 12 months and liabilities of 859.5 billion due beyond. On the other hand, he had 450.0 billion yen in cash and 906.0 billion yen in receivables due within one year. Thus, its liabilities exceed the sum of its cash and its (short-term) receivables by 877.5 billion euros.
While that might sound like a lot, it’s not that bad since Larsen & Toubro has a massive market cap of 2.39 tonnes, and could therefore likely strengthen its balance sheet by raising capital if needed. But it is clear that it is absolutely necessary to take a close look at whether it can manage its debt without dilution.
We use two main ratios to inform us about the levels of debt compared to earnings. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its profit before interest and taxes (EBIT) covers its interest expense (or its coverage of interest, for short). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).
Larsen & Toubro has a debt / EBITDA ratio of 4.6 and its EBIT covers its interest expense 5.1 times. Overall, this implies that while we wouldn’t like to see debt levels rise, we believe it can handle its current leverage. It is also important to note that Larsen & Toubro increased its EBIT by a very respectable 27% last year, thus improving its ability to repay its debt. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Larsen & Toubro’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 analyst earnings forecast report interesting.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Over the past three years, Larsen & Toubro has recorded free cash flow of 42% of its EBIT, which is lower than expected. This low cash conversion makes debt management more difficult.
Our point of view
Based on our analysis, Larsen & Toubro’s EBIT growth rate should indicate that it will not have too many problems with its debt. However, our other observations were not so encouraging. In particular, net debt to EBITDA gives us shivers. Looking at all this data, we feel a little cautious about Larsen & Toubro’s debt levels. While we understand that debt can improve returns on equity, we suggest shareholders watch their debt level closely, lest they increase. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks lie on the balance sheet – far from it. For example, we discovered 5 warning signs for Larsen & Toubro (1 makes us a little uncomfortable!) Which you should be aware of before investing here.
At the end of the day, it’s often best to focus on businesses that don’t have net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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