We Think Wesfarmers (ASX:WES) Can Manage Its Debt With Ease

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 note that Wesfarmers Limited (ASX:WES) 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 is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Wesfarmers

What Is Wesfarmers's Net Debt?

The image below, which you can click on for greater detail, shows that Wesfarmers had debt of AU$1.99b at the end of December 2020, a reduction from AU$2.95b over a year. But it also has AU$2.68b in cash to offset that, meaning it has AU$689.0m net cash.

How Strong Is Wesfarmers' Balance Sheet?

The latest balance sheet data shows that Wesfarmers had liabilities of AU$8.20b due within a year, and liabilities of AU$7.71b falling due after that. Offsetting these obligations, it had cash of AU$2.68b as well as receivables valued at AU$894.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$12.3b.

Since publicly traded Wesfarmers shares are worth a very impressive total of AU$63.1b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Wesfarmers boasts net cash, so it's fair to say it does not have a heavy debt load!

Another good sign is that Wesfarmers has been able to increase its EBIT by 28% in twelve months, making it easier to pay down debt. 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 Wesfarmers'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. Wesfarmers may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last three years, Wesfarmers recorded free cash flow worth a fulsome 85% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing up

Although Wesfarmers's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$689.0m. The cherry on top was that in converted 85% of that EBIT to free cash flow, bringing in AU$3.8b. So is Wesfarmers's debt a risk? It doesn't seem so to us. 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. For example, we've discovered 1 warning sign for Wesfarmers that you should be aware of before investing here.

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. 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.
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