The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Tapestry, Inc. (NYSE:TPR) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Tapestry’s Net Debt?
The chart below, which you can click on for greater detail, shows that Tapestry had US$1.60b in debt in March 2019; about the same as the year before. However, it does have US$1.34b in cash offsetting this, leading to net debt of about US$264.9m.
How Strong Is Tapestry’s Balance Sheet?
The latest balance sheet data shows that Tapestry had liabilities of US$996.6m due within a year, and liabilities of US$2.44b falling due after that. Offsetting this, it had US$1.34b in cash and US$326.6m in receivables that were due within 12 months. So it has liabilities totalling US$1.77b more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Tapestry is worth US$8.08b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Tapestry has a low net debt to EBITDA ratio of only 0.24. And its EBIT covers its interest expense a whopping 16.5 times over. So we’re pretty relaxed about its super-conservative use of debt. On the other hand, Tapestry’s EBIT dived 11%, over the last year. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 Tapestry 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Tapestry 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.
The good news is that Tapestry’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its EBIT growth rate. All these things considered, it appears that Tapestry can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. We’d be motivated to research the stock further if we found out that Tapestry insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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