David Iben put it well 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 can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. Mostly, Leonardo Spa (BIT: LDO) carries a debt. But does this debt worry shareholders?
What risk does debt entail?
Debts 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. In the worst case scenario, a business can go bankrupt if it cannot pay its creditors. 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. Of course, many companies use debt to finance their growth without negative consequences. 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 analysis for Leonardo
What is Leonardo’s debt?
The image below, which you can click for more details, shows that Leonardo had a debt of 4.61 billion euros at the end of March 2021, a reduction from 4.86 billion euros on a year. However, it has 408.0 million euros in cash offsetting this, which leads to net debt of around 4.21 billion euros.
A look at Leonardo’s responsibilities
According to the latest published balance sheet, Leonardo had liabilities of 6.79 billion euros within 12 months and liabilities of 5.53 billion euros due beyond 12 months. On the other hand, it had cash of € 408.0 million and € 2.98 billion in receivables within one year. Its liabilities therefore amount to € 8.93 billion more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the 4.09 billion euro company, like a colossus towering over mere mortals. So we would be watching its record closely, without a doubt. Ultimately, Leonardo would likely need a major recapitalization if his creditors demanded repayment.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). Thus, we look at debt over earnings with and without amortization charges.
With a net debt on EBITDA of 2.7, Leonardo has a fairly significant debt. On the positive side, its EBIT was 7.5 times its interest expense and its net debt to EBITDA was quite high, at 2.7. One way Leonardo could beat his debt would be to stop borrowing more but continue to increase his EBIT by around 16%, like he did last year. There is no doubt that we learn the most about debt from the balance sheet. But it’s future profits, more than anything, that will determine Leonardo’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.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, Leonardo has recorded negative free cash flow, in total. Debt is much riskier for companies with unreliable free cash flow, so shareholders should hope that past spending will produce free cash flow in the future.
Our point of view
To be frank, Leonardo’s conversion of EBIT to free cash flow and his track record of controlling his total liabilities make us rather uncomfortable with his debt levels. But on the positive side, its EBIT growth rate is a good sign and makes us more optimistic. Overall, it seems to us that Leonardo’s balance sheet is really very risky for the company. For this reason, we are fairly cautious about the stock, and we believe shareholders should keep a close eye on its liquidity. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, Leonardo has 3 warning signs (and 1 which is significant) we think you should be aware of.
If, after all of this, you’re more interested in a fast-growing company with a strong balance sheet, take a quick look at our list of cash-flow net-growth stocks.
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