Yahoo Finance Linamar (TSE:LNR) Takes On Some Risk With Its Use Of Debt
David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Linamar Corporation (TSE:LNR) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
Check out our latest analysis for Linamar
What Is Linamar's Net Debt?
The image below, which you can click on for greater detail, shows that Linamar had debt of CA$2.38b at the end of June 2019, a reduction from CA$2.57b over a year. However, because it has a cash reserve of CA$437.6m, its net debt is less, at about CA$1.94b.
How Strong Is Linamar's Balance Sheet?
According to the last reported balance sheet, Linamar had liabilities of CA$1.61b due within 12 months, and liabilities of CA$2.63b due beyond 12 months. On the other hand, it had cash of CA$437.6m and CA$1.65b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$2.15b.
This is a mountain of leverage relative to its market capitalization of CA$2.82b. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
We'd say that Linamar's moderate net debt to EBITDA ratio ( being 1.8), indicates prudence when it comes to debt. And its commanding EBIT of 17.4 times its interest expense, implies the debt load is as light as a peacock feather. Sadly, Linamar's EBIT actually dropped 5.6% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Linamar'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 report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Linamar recorded free cash flow of 40% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
Neither Linamar's ability to handle its total liabilities nor its EBIT growth rate gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Linamar is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Given our hesitation about the stock, it would be good to know if Linamar insiders have sold any shares recently. You click here to find out if insiders have sold recently.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.
