Is JD Sports Fashion (LON:JD.) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, JD Sports Fashion Plc (LON:JD.) does carry debt. But the real question is whether this debt is making the company risky.

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for JD Sports Fashion

How Much Debt Does JD Sports Fashion Carry?

As you can see below, JD Sports Fashion had UK£114.6m of debt at July 2023, down from UK£124.8m a year prior. However, it does have UK£1.39b in cash offsetting this, leading to net cash of UK£1.28b.

A Look At JD Sports Fashion's Liabilities

Zooming in on the latest balance sheet data, we can see that JD Sports Fashion had liabilities of UK£2.50b due within 12 months and liabilities of UK£2.92b due beyond that. On the other hand, it had cash of UK£1.39b and UK£292.1m worth of receivables due within a year. So its liabilities total UK£3.73b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of UK£6.20b, so it does suggest shareholders should keep an eye on JD Sports Fashion's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Despite its noteworthy liabilities, JD Sports Fashion boasts net cash, so it's fair to say it does not have a heavy debt load!

The good news is that JD Sports Fashion has increased its EBIT by 7.3% over twelve months, which should ease any concerns about debt repayment. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine JD Sports Fashion'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 JD Sports Fashion 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, JD Sports Fashion generated free cash flow amounting to a very robust 80% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

While JD Sports Fashion does have more liabilities than liquid assets, it also has net cash of UK£1.28b. The cherry on top was that in converted 80% of that EBIT to free cash flow, bringing in UK£813m. So we are not troubled with JD Sports Fashion's debt use. 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. Be aware that JD Sports Fashion is showing 3 warning signs in our investment analysis , you should know about...

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.