Stock Analysis

Wesfarmers (ASX:WES) Could Easily Take On More Debt

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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.' 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. As with many other companies Wesfarmers Limited (ASX:WES) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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 Wesfarmers

What Is Wesfarmers's Debt?

As you can see below, at the end of June 2021, Wesfarmers had AU$3.02b of debt, up from AU$2.66b a year ago. Click the image for more detail. But on the other hand it also has AU$3.02b in cash, leading to a AU$1.00m net cash position.

ASX:WES Debt to Equity History December 19th 2021

How Strong Is Wesfarmers' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Wesfarmers had liabilities of AU$7.92b due within 12 months and liabilities of AU$8.58b due beyond that. Offsetting this, it had AU$3.02b in cash and AU$1.25b in receivables that were due within 12 months. So it has liabilities totalling AU$12.2b more than its cash and near-term receivables, combined.

Given Wesfarmers has a humongous market capitalization of AU$66.6b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Wesfarmers also has more cash than debt, so we're pretty confident it can manage its debt safely.

Also positive, Wesfarmers grew its EBIT by 28% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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. During the last three years, Wesfarmers generated free cash flow amounting to a very robust 85% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

While Wesfarmers does have more liabilities than liquid assets, it also has net cash of AU$1.00m. And it impressed us with free cash flow of AU$2.5b, being 85% of its EBIT. So is Wesfarmers's debt a risk? It doesn't seem so to us. 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. Be aware that Wesfarmers is showing 1 warning sign in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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