Is L'Oréal (EPA:OR) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that L'Oréal S.A. (EPA:OR) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for L'Oréal

What Is L'Oréal's Net Debt?

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. However, its balance sheet shows it holds €6.41b in cash, so it actually has €5.55b net cash.

How Strong 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 this, it had €6.41b in cash and €4.38b in receivables that were due within 12 months. So its liabilities total €3.81b more than the combination of its cash and short-term receivables.

This state of affairs indicates that L'Oréal's balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the €204.5b company is short on cash, but still worth keeping an eye on the balance sheet. Despite its noteworthy liabilities, L'Oréal boasts net cash, so it's fair to say it does not have a heavy debt load!

But the other side of the story is that L'Oréal saw its EBIT decline by 6.1% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 company can only pay off debt with cold hard cash, not accounting profits. 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. During the last three years, L'Oréal generated free cash flow amounting to a very robust 92% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

We could understand if investors are concerned about L'Oréal's liabilities, but we can be reassured by the fact it has has net cash of €5.55b. And it impressed us with free cash flow of €5.5b, being 92% of its EBIT. So is L'Oréal's debt a risk? It doesn't seem so to us. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of L'Oréal's earnings per share history for free.

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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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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