Here's Why Woolworths Group (ASX:WOW) Has A Meaningful Debt Burden

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Woolworths Group Limited (ASX:WOW) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. 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 Woolworths Group

How Much Debt Does Woolworths Group Carry?

As you can see below, Woolworths Group had AU$4.23b of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have AU$1.70b in cash offsetting this, leading to net debt of about AU$2.54b.

A Look At Woolworths Group's Liabilities

The latest balance sheet data shows that Woolworths Group had liabilities of AU$12.5b due within a year, and liabilities of AU$15.4b falling due after that. Offsetting this, it had AU$1.70b in cash and AU$996.0m in receivables that were due within 12 months. So it has liabilities totalling AU$25.2b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of AU$38.8b, so it does suggest shareholders should keep an eye on Woolworths Group's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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.

Woolworths Group has a very low debt to EBITDA ratio of 1.0 so it is strange to see weak interest coverage, with last year's EBIT being only 2.0 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Shareholders should be aware that Woolworths Group's EBIT was down 52% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Woolworths Group 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Woolworths Group recorded free cash flow worth 73% 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.

Our View

Both Woolworths Group's EBIT growth rate and its interest cover were discouraging. But at least its conversion of EBIT to free cash flow is a gleaming silver lining to those clouds. When we consider all the factors discussed, it seems to us that Woolworths Group is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 2 warning signs with Woolworths Group (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.