Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about. 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. As with many other companies Kering SA (EPA:KER) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Kering’s Debt?
As you can see below, Kering had €4.59b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it also had €2.46b in cash, and so its net debt is €2.13b.
How Healthy Is Kering’s Balance Sheet?
The latest balance sheet data shows that Kering had liabilities of €8.66b due within a year, and liabilities of €7.95b falling due after that. Offsetting these obligations, it had cash of €2.46b as well as receivables valued at €1.07b due within 12 months. So its liabilities total €13.1b more than the combination of its cash and short-term receivables.
Since publicly traded Kering shares are worth a very impressive total of €71.1b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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.
Kering has a low net debt to EBITDA ratio of only 0.43. And its EBIT covers its interest expense a whopping 40.4 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we’re happy to report that Kering has boosted its EBIT by 34%, thus reducing the spectre of future debt repayments. 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 Kering 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Kering produced sturdy free cash flow equating to 73% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Kering’s impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Overall, we don’t think Kering is taking any bad risks, as its debt load seems modest. So we’re not worried about the use of a little leverage on the balance sheet. 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. For instance, we’ve identified 1 warning sign for Kering that you should be aware of.
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.
If you spot an error that warrants correction, please contact the editor at email@example.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.
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