Lear (NYSE:LEA) seems to be using debt quite wisely

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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 synonymous with risk.” When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. We note that Lear Company (NYSE:LEA) has debt on its balance sheet. But the more important question is: what risk does this debt create?

What risk does debt carry?

Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. If things go really bad, lenders can take over the business. However, a more usual (but still expensive) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.

See our latest analysis for Lear

What is Lear’s Net Debt?

You can click on the graph below for historical numbers, but it shows that as of December 2021, Lear had $2.60 billion in debt, an increase from $2.31 billion, year-over-year . However, since he has a cash reserve of $1.32 billion, his net debt is less, at around $1.27 billion.

NYSE:LEA Debt to Equity History March 10, 2022

How strong is Lear’s balance sheet?

According to the last published balance sheet, Lear had liabilities of $4.76 billion due within 12 months and liabilities of $3.78 billion due beyond 12 months. On the other hand, it had liquidities of 1.32 billion dollars and 3.25 billion dollars of receivables at less than one year. It therefore has liabilities totaling $3.97 billion more than its cash and short-term receivables, combined.

This shortfall isn’t that bad because Lear is worth $8.43 billion and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. But we definitely want to keep our eyes peeled for indications that its debt is too risky.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). Thus, we consider debt to earnings with and without amortization and depreciation expense.

Lear has net debt of just 0.93 times EBITDA, indicating that he is certainly not an imprudent borrower. And this view is supported by strong interest coverage, with EBIT amounting to 8.7 times interest expense over the past year. On top of that, Lear has grown its EBIT by 35% over the last twelve months, and this growth will make it easier to manage its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether Lear can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Lear has recorded free cash flow of 37% of its EBIT, which is lower than expected. It’s not great when it comes to paying off debt.

Our point of view

The good news is that Lear’s demonstrated ability to increase EBIT thrills us like a fluffy puppy does a toddler. But truth be told, we think his total passive level undermines that impression a bit. All told, it looks like Lear can comfortably handle his current level of debt. On the plus side, this leverage can increase shareholder returns, but the potential downside is greater risk of loss, so it’s worth keeping an eye on the balance sheet. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. To this end, you should be aware of the 2 warning signs we spotted with Lear.

In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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