David Iben put it right when he said: “Volatility is not a risk that is close to our hearts. What matters to us is to avoid the permanent loss of capital. So it seems like smart money knows that debt – which is usually linked to bankruptcies – is a very important factor when you assess the risk of a business. Mostly, LTC Co., Ltd (KOSDAQ: 170920) is in debt. But does this debt worry shareholders?

When is debt dangerous?

Debt and other liabilities become risky for a business when it cannot easily meet these 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 ruthlessly liquidated by their bankers. However, a more common (but still costly) situation is where a company has to issue shares at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, debt can be an important tool in businesses, especially large cap companies. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.

Check out our latest review for LTCLtd

What is LTCLtd’s net debt?

The graph below, which you can click for more details, shows that LTCLtd had 60.5 billion in debt as of September 2020; about the same as the year before. However, because it has a cash reserve of â‚© 42.6 billion, its net debt is lower, at around â‚© 17.9 billion.

A look at the responsibilities of LTCLtd

We can see from the most recent balance sheet that LTCLtd had liabilities of 46.2 billion falling due within one year and liabilities of â‚© 33.7 billion beyond. In return for these obligations, he had cash of Ace 42.6 billion as well as receivables valued at â‚© 20.7 billion within 12 months. Thus, its liabilities total $ 16.7 billion more than the combination of its cash and short-term receivables.

Given that listed LTCLtd shares are worth au 95.9 billion in total, it seems unlikely that this level of liabilities is a major threat. But there are enough liabilities that we would certainly recommend that shareholders continue to monitor the balance sheet going forward.

We use two main ratios to tell us about leverage versus earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is the number of times its earnings before interest and taxes (EBIT) covers its interest expense (or interest coverage, in short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt over EBITDA) and the actual interest charges associated with that debt (with its interest coverage ratio).

LTCLtd has a very low debt to EBITDA ratio of 1.5 so it is strange to see low interest coverage as last year’s EBIT was only 1.8 times the interest expense. So while we’re not necessarily alarmed, we think his debt is far from trivial. Importantly, LTCLtd’s EBIT has fallen 28% over the past twelve months. If this decline continues, it will be more difficult to pay off the debt than to sell foie gras at a vegan convention. The balance sheet is clearly the area to focus on when analyzing debt. But it is the profits of LTCLtd that will influence the balance sheet in the future. So if you want to know more about its earnings, it might be worth checking out this chart of its long term trend.

Finally, a business needs free cash flow to pay off debt; accounting profits do not reduce it. We therefore always check the part of this EBIT which translates into free cash flow. Over the past two years, LTCLtd has generated a very robust 85% free cash flow of its EBIT, more than we expected. This puts him in a very strong position to pay off his debt.

Our point of view

Neither LTCLtd’s ability to increase its EBIT nor its interest coverage gave us confidence in its ability to take on more debt. But the good news is that it seems to be able to easily convert EBIT into free cash flow. Looking at all of the angles mentioned above, it seems to us that LTCLtd is a somewhat risky investment due to its debt. Not all risks are bad, as they can increase stock returns if they pay off, but this risk of leverage is worth considering. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. Concrete example: we have spotted 6 warning signs for LTCLtd you should be aware of this, and 2 of them are a bit disturbing.

At the end of the day, it’s often best to focus on businesses with no 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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