Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Shoe Zone plc (LON:SHOE) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Shoe Zone's Debt?
As you can see below, Shoe Zone had UK£4.40m of debt at October 2021, down from UK£7.00m a year prior. However, it does have UK£19.0m in cash offsetting this, leading to net cash of UK£14.6m.
How Strong Is Shoe Zone's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Shoe Zone had liabilities of UK£40.9m due within 12 months and liabilities of UK£33.6m due beyond that. Offsetting this, it had UK£19.0m in cash and UK£2.05m in receivables that were due within 12 months. So it has liabilities totalling UK£53.5m more than its cash and near-term receivables, combined.
This deficit is considerable relative to its market capitalization of UK£61.2m, so it does suggest shareholders should keep an eye on Shoe Zone's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, Shoe Zone also has more cash than debt, so we're pretty confident it can manage its debt safely.
Although Shoe Zone made a loss at the EBIT level, last year, it was also good to see that it generated UK£13m in EBIT over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shoe Zone 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While Shoe Zone 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. Happily for any shareholders, Shoe Zone actually produced more free cash flow than EBIT over the last year. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Although Shoe Zone's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£14.6m. The cherry on top was that in converted 215% of that EBIT to free cash flow, bringing in UK£29m. So we don't have any problem with Shoe Zone's use of debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 4 warning signs for Shoe Zone (1 doesn't sit too well with us) you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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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.
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