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, Wesfarmers Limited (ASX:WES) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Wesfarmers’s Debt?
You can click the graphic below for the historical numbers, but it shows that Wesfarmers had AU$2.95b of debt in December 2019, down from AU$3.48b, one year before. On the flip side, it has AU$436.0m in cash leading to net debt of about AU$2.52b.
How Strong Is Wesfarmers’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Wesfarmers had liabilities of AU$7.23b due within 12 months and liabilities of AU$9.13b due beyond that. Offsetting this, it had AU$436.0m in cash and AU$949.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$15.0b.
Wesfarmers has a very large market capitalization of AU$46.1b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Wesfarmers has a low net debt to EBITDA ratio of only 0.79. And its EBIT easily covers its interest expense, being 10.4 times the size. So we’re pretty relaxed about its super-conservative use of debt. Fortunately, Wesfarmers grew its EBIT by 3.0% in the last year, making that debt load look even more manageable. 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 Wesfarmers 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Wesfarmers recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Happily, Wesfarmers’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its interest cover also supports that impression! When we consider the range of factors above, it looks like Wesfarmers is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we’ve spotted 1 warning sign for Wesfarmers 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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