Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 adidas AG (ETR:ADS) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is adidas's Debt?
The image below, which you can click on for greater detail, shows that at December 2020 adidas had debt of €3.17b, up from €1.64b in one year. But it also has €4.24b in cash to offset that, meaning it has €1.07b net cash.
How Healthy Is adidas' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that adidas had liabilities of €8.83b due within 12 months and liabilities of €5.54b due beyond that. On the other hand, it had cash of €4.24b and €2.71b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €7.41b.
Of course, adidas has a titanic market capitalization of €51.0b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, adidas boasts net cash, so it's fair to say it does not have a heavy debt load!
Importantly, adidas's EBIT fell a jaw-dropping 70% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine adidas'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. While adidas has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, adidas generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
While adidas does have more liabilities than liquid assets, it also has net cash of €1.07b. The cherry on top was that in converted 87% of that EBIT to free cash flow, bringing in €1.0b. So we don't have any problem with adidas's use of debt. 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. We've identified 3 warning signs with adidas , 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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