Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk’. So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that Future Lifestyle Fashions Limited (NSE:FLFL) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Future Lifestyle Fashions’s Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Future Lifestyle Fashions had debt of ₹9.13b, up from ₹9.0k in one year. However, it also had ₹1.49b in cash, and so its net debt is ₹7.65b.
How Healthy Is Future Lifestyle Fashions’s Balance Sheet?
According to the last reported balance sheet, Future Lifestyle Fashions had liabilities of ₹33.6b due within 12 months, and liabilities of ₹15.2b due beyond 12 months. On the other hand, it had cash of ₹1.49b and ₹6.99b worth of receivables due within a year. So its liabilities total ₹40.3b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Future Lifestyle Fashions has a market capitalization of ₹84.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Looking at its net debt to EBITDA of 0.92 and interest cover of 2.6 times, it seems to us that Future Lifestyle Fashions is probably using debt in a pretty reasonable way. So we’d recommend keeping a close eye on the impact financing costs are having on the business. Also relevant is that Future Lifestyle Fashions has grown its EBIT by a very respectable 24% in the last year, thus enhancing its ability to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Future Lifestyle Fashions can strengthen its balance sheet over time. 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Future Lifestyle Fashions produced sturdy free cash flow equating to 61% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
When it comes to the balance sheet, the standout positive for Future Lifestyle Fashions was the fact that it seems able to grow its EBIT confidently. However, our other observations weren’t so heartening. To be specific, it seems about as good at covering its interest expense with its EBIT as wet socks are at keeping your feet warm. When we consider all the elements mentioned above, it seems to us that Future Lifestyle Fashions is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we’ve spotted with Future Lifestyle Fashions .
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.