Woolworths Group (ASX:WOW) Has A Pretty Healthy 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Woolworths Group Limited (ASX:WOW) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Woolworths Group

What Is Woolworths Group's Debt?

As you can see below, Woolworths Group had AU$2.63b of debt at January 2021, down from AU$3.02b a year prior. However, it also had AU$2.14b in cash, and so its net debt is AU$491.0m.

A Look At Woolworths Group's Liabilities

The latest balance sheet data shows that Woolworths Group had liabilities of AU$13.3b due within a year, and liabilities of AU$16.5b falling due after that. Offsetting these obligations, it had cash of AU$2.14b as well as receivables valued at AU$853.0m due within 12 months. So its liabilities total AU$26.8b more than the combination of its cash and short-term receivables.

Woolworths Group has a very large market capitalization of AU$51.4b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. Carrying virtually no net debt, Woolworths Group has a very light debt load indeed.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Looking at its net debt to EBITDA of 0.11 and interest cover of 4.3 times, it seems to us that Woolworths Group is probably using debt in a pretty reasonable way. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. It is well worth noting that Woolworths Group's EBIT shot up like bamboo after rain, gaining 32% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Woolworths Group'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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Woolworths Group recorded free cash flow worth 60% 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.

Our View

The good news is that Woolworths Group's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its interest cover does undermine this impression a bit. All these things considered, it appears that Woolworths Group 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for Woolworths Group that 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.

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