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Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from risk.” 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. Mostly, Legrand SA (EPA: LR) carries the debt. But does this debt concern shareholders?
Why Does Debt Bring Risk?
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. If things really go wrong, lenders can take over the business. 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, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we think of a business’s use of debt, we first look at cash flow and debt together.
See our latest analysis for Legrand
How many debts does Legrand carry?
You can click on the graph below for historical figures, but it shows that in March 2021, Legrand had 4.87 billion euros in debt, an increase from 4.36 billion euros, on a year. However, he has € 2.76 billion in cash to make up for this, leading to net debt of around € 2.11 billion.
Is Legrand’s balance sheet healthy?
Zooming in on the latest balance sheet data, we see that Legrand had liabilities of € 2.66 billion at 12 months and liabilities of € 5.27 billion due beyond. In compensation for these obligations, he had cash of € 2.76 billion as well as receivables valued at € 862.9 million within 12 months. Its liabilities thus exceed the sum of its cash and its (short-term) receivables by 4.31 billion euros.
Given that listed Legrand shares are worth a very impressive total of 24.0 billion euros, 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 measure a company’s debt load relative to its earning capacity by looking at its net debt divided by its earnings before interest, taxes, depreciation, and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT) covers its interest costs (interest coverage). Thus, we consider debt versus earnings with and without amortization charges.
Legrand’s net debt to EBITDA ratio of around 1.5 suggests only a moderate recourse to debt. And its strong coverage interest of 12.4 times, makes us even more comfortable. On the other hand, Legrand has seen its EBIT fall by 5.4% over the last twelve months. This kind of decline, if it continues, will obviously make the debt more difficult to manage. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Legrand will be able to strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts‘ earnings forecasts.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Legrand has generated free cash flow amounting to a very solid 84% of its EBIT, more than expected. This puts him in a very strong position to pay off the debt.
Our point of view
Fortunately, Legrand’s impressive interest coverage means it has the upper hand over its debt. But frankly, we think its EBIT growth rate undermines that impression a bit. When you consider the range of factors above, it seems Legrand is being fairly reasonable with its use of debt. While this carries some risk, it can also improve returns for shareholders. 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. To do this, you need to know the 1 warning sign we spotted with Legrand.
If you are interested in investing in companies that can generate profits without the burden of debt, check out this page. free list of growing companies that have net cash on the balance sheet.
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This Simply Wall St article is general in nature. 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 documents. Simply Wall St has no position in the mentioned stocks.
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