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. 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. Importantly, NIKE, Inc. (NYSE:NKE) does carry debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does NIKE Carry?
The image below, which you can click on for greater detail, shows that at November 2019 NIKE had debt of US$3.77b, up from US$3.48b in one year. However, it also had US$3.50b in cash, and so its net debt is US$266.0m.
How Strong Is NIKE’s Balance Sheet?
According to the last reported balance sheet, NIKE had liabilities of US$8.26b due within 12 months, and liabilities of US$8.99b due beyond 12 months. On the other hand, it had cash of US$3.50b and US$4.79b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$8.96b.
Given NIKE has a humongous market capitalization of US$156.2b, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. But either way, NIKE has virtually no net debt, so it’s fair to say it does not have a heavy debt load!
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
NIKE has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.045 and EBIT of 103 times the interest expense. So relative to past earnings, the debt load seems trivial. And we also note warmly that NIKE grew its EBIT by 11% last year, making its debt load easier to handle. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine NIKE’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, NIKE recorded free cash flow worth 76% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that NIKE’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that’s just the beginning of the good news since its net debt to EBITDA is also very heartening. Overall, we don’t think NIKE is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. Take risks, for example – NIKE has 1 warning sign we think 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.
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. Thank you for reading.