Kohl's (NYSE:KSS) Has A Somewhat Strained Balance Sheet

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Kohl's Corporation (NYSE:KSS) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Kohl's

How Much Debt Does Kohl's Carry?

You can click the graphic below for the historical numbers, but it shows that Kohl's had US$1.86b of debt in November 2019, down from US$2.27b, one year before. On the flip side, it has US$490.0m in cash leading to net debt of about US$1.37b.

How Healthy Is Kohl's's Balance Sheet?

The latest balance sheet data shows that Kohl's had liabilities of US$4.08b due within a year, and liabilities of US$6.31b falling due after that. Offsetting this, it had US$490.0m in cash and US$29.0m in receivables that were due within 12 months. So its liabilities total US$9.87b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of US$6.86b, we think shareholders really should watch Kohl's's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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 Kohl's's low debt to EBITDA ratio of 0.62 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.9 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. The bad news is that Kohl's saw its EBIT decline by 16% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 Kohl's 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Kohl's recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

On the face of it, Kohl's's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that Kohl's's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Kohl's is showing 2 warning signs in our investment analysis , you should know about...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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