Here's Why L'Oréal (EPA:OR) Can Manage Its Debt Responsibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 L'Oréal S.A. (EPA:OR) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for L'Oréal

How Much Debt Does L'Oréal Carry?

The chart below, which you can click on for greater detail, shows that L'Oréal had €864.9m in debt in December 2020; about the same as the year before. But it also has €6.41b in cash to offset that, meaning it has €5.54b net cash.

How Healthy Is L'Oréal's Balance Sheet?

We can see from the most recent balance sheet that L'Oréal had liabilities of €11.1b falling due within a year, and liabilities of €3.48b due beyond that. Offsetting these obligations, it had cash of €6.41b as well as receivables valued at €3.75b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €4.46b.

Of course, L'Oréal has a titanic market capitalization of €178.2b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, L'Oréal also has more cash than debt, so we're pretty confident it can manage its debt safely.

On the other hand, L'Oréal's EBIT dived 19%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine L'Oréal'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. L'Oréal 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, L'Oréal recorded free cash flow worth a fulsome 96% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that L'Oréal has €5.54b in net cash. The cherry on top was that in converted 96% of that EBIT to free cash flow, bringing in €5.5b. So we are not troubled with L'Oréal's debt use. Over time, share prices tend to follow earnings per share, so if you're interested in L'Oréal, you may well want to click here to check an interactive graph of its earnings per share history.

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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