Warren Buffett famously said that 'Volatility is not at all synonymous with risk'. So it's clear that you need to consider debt when considering the risk of any particular stock, because too much debt can sink a company. Importantly, Lifestyle Communities Limited (ASX:LIC) does have debt. But should shareholders be worried about its use of debt?
Why is debt risky?
Debt is a tool to help companies grow, but if a company can't pay back its lenders, the company is at their mercy. Ultimately, if a company can't meet its legal obligations to repay its debt, shareholders could get nothing. However, a more common (but still costly) situation is where a company has to dilute shareholders' equity at a cheap price just to get the debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when thinking about how much debt a company uses is to look at cash and debt together.
View our latest analysis for Lifestyle Communities
How much net debt does Lifestyle Communities have?
Click on the chart below for the historical numbers: Lifestyle Communities had debt of AU$324m at June 2024, down from AU$371m a year ago, and since it doesn't have much cash, its net debt is about the same.
ASX:LIC Debt to Capital Ratio History 16 August 2024
Lifestyle Community Debt
Looking at the most recent balance sheet, we can see that Lifestyle Communities had liabilities of AU$160.7m due within a year, and liabilities of AU$519.2m due beyond that. Offsetting this, it has cash of AU$4.1m and receivables of AU$8.3m due within 12 months. This means that its total liabilities are AU$667.5m more than the combination of its cash and short-term receivables.
This deficit is substantial relative to the company's market capitalization of A$1.01 billion, and shareholders should keep a close eye on Lifestyle Communities' use of debt: shareholders would likely face severe dilution if lenders demand that they strengthen the balance sheet.
In order to assess a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (interest cover ratio), thus taking into account both the absolute quantum of debt as well as the interest rate paid on it.
Lifestyle Community's debt-to-EBITDA ratio of 11.9 is fairly high, suggesting it has a significant amount of debt. However, interest coverage is fairly strong at 6.7, which is a good sign. Shareholders should be aware that Lifestyle Community's EBIT fell 34% over the last year. If this decline continues, paying down debt will be harder than selling foie gras at a vegan convention. When analysing debt, the balance sheet is the focus. But ultimately, whether Lifestyle Community can strengthen its balance sheet over the long term will depend on the future profitability of the business. So if you're focused on the future, you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay down debt – accounting profits alone aren't enough, so the logical step is to look at the ratio of EBIT to actual free cash flow. Over the last three years, Lifestyle Communities has had significantly negative free cash flow in total – and while investors will no doubt be hoping that this will reverse at some point, it's clear that its use of debt means it's riskier.
Our take
Frankly, Lifestyle Communities' EBIT to free cash flow conversion and track record of EBIT growth (or lack thereof) both make us pretty worried about the company's debt levels. However, looking on the bright side, its interest cover is a good sign and makes us more optimistic. We clearly view the company as quite risky as a result of the strength of Lifestyle Communities' balance sheet. For this reason, we are pretty cautious about the stock and think shareholders should pay close attention to its liquidity. There's no doubt that we learn most about debt from the balance sheet. But ultimately, all companies have risks that exist off the balance sheet. We've identified 3 warning signs with Lifestyle Communities and understanding these should be part of your investment process.
If you're interested in investing in companies that can grow profits without the burden of debt, then check out this free list of growing companies that have net cash on their balance sheets.
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This article by Simply Wall St is of general nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology, and our articles are not intended as financial advice. It is not a recommendation to buy or sell stocks, and does not take into account your objectives or financial situation. We aim to provide long-term analysis driven by fundamental data. Please note that our analysis may not take into account the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any of the stocks mentioned herein.
