Is WPP (LON:WPP) A Risky Investment?

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. As with many other companies WPP plc (LON:WPP) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out the opportunities and risks within the GB Media industry.

How Much Debt Does WPP Carry?

As you can see below, WPP had UK£4.91b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has UK£1.78b in cash leading to net debt of about UK£3.13b.

How Healthy Is WPP's Balance Sheet?

According to the last reported balance sheet, WPP had liabilities of UK£14.9b due within 12 months, and liabilities of UK£7.86b due beyond 12 months. Offsetting this, it had UK£1.78b in cash and UK£11.5b in receivables that were due within 12 months. So it has liabilities totalling UK£9.44b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's massive market capitalization of UK£9.20b, we think shareholders really should watch WPP's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

WPP's net debt of 2.1 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 7.0 times its interest expenses harmonizes with that theme. Importantly, WPP grew its EBIT by 35% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if WPP can strengthen its balance sheet over time. 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. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, WPP actually produced more free cash flow than EBIT over the last two years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Happily, WPP's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But the stark truth is that we are concerned by its level of total liabilities. All these things considered, it appears that WPP can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. For example WPP has 2 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.