Is AJ Lucas Group (ASX:AJL) Using Too Much Debt?

Simply Wall St

Tue, Aug 27, 2019, 7:53 PM

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. Importantly, AJ Lucas Group Limited (ASX:AJL) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for AJ Lucas Group

How Much Debt Does AJ Lucas Group Carry?

The chart below, which you can click on for greater detail, shows that AJ Lucas Group had AU$108.9m in debt in December 2018; about the same as the year before. However, it does have AU$10.1m in cash offsetting this, leading to net debt of about AU$98.7m.

ASX:AJL Historical Debt, August 28th 2019

How Strong Is AJ Lucas Group's Balance Sheet?

The latest balance sheet data shows that AJ Lucas Group had liabilities of AU$67.5m due within a year, and liabilities of AU$76.0m falling due after that. Offsetting these obligations, it had cash of AU$10.1m as well as receivables valued at AU$24.8m due within 12 months. So it has liabilities totalling AU$108.6m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of AU$165.0m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While we wouldn't worry about AJ Lucas Group's net debt to EBITDA ratio of 4.3, we think its super-low interest cover of 1.1 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, the silver lining was that AJ Lucas Group achieved a positive EBIT of AU$18m in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if AJ Lucas Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, AJ Lucas Group saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both AJ Lucas Group's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. We're quite clear that we consider AJ Lucas Group to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. Even though AJ Lucas Group lost money on the bottom line, its positive EBIT suggests the business itself has potential. So you might want to check outhow earnings have been trending over the last few years.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.

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