Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Lands' End, Inc. (NASDAQ:LE) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Lands' End Carry?
The image below, which you can click on for greater detail, shows that at April 2022 Lands' End had debt of US$370.5m, up from US$336.5m in one year. However, it does have US$22.0m in cash offsetting this, leading to net debt of about US$348.4m.
How Strong Is Lands' End's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Lands' End had liabilities of US$241.0m due within 12 months and liabilities of US$442.1m due beyond that. Offsetting these obligations, it had cash of US$22.0m as well as receivables valued at US$52.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$609.0m.
When you consider that this deficiency exceeds the company's US$426.4m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
In order to size up 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 (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While we wouldn't worry about Lands' End's net debt to EBITDA ratio of 3.1, we think its super-low interest cover of 2.1 times is a sign of high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Another concern for investors might be that Lands' End's EBIT fell 11% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Lands' End's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Lands' End created free cash flow amounting to 9.7% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
Our View
To be frank both Lands' End's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its EBIT growth rate fails to inspire much confidence. After considering the datapoints discussed, we think Lands' End has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Lands' End , and understanding them should be part of your investment process.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.
