Here's Why WH Smith (LON:SMWH) Can Manage Its Debt Responsibly

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 note that WH Smith PLC (LON:SMWH) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for WH Smith

What Is WH Smith's Net Debt?

As you can see below, WH Smith had UK£422.0m of debt, at February 2023, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of UK£46.0m, its net debt is less, at about UK£376.0m.

How Strong Is WH Smith's Balance Sheet?

The latest balance sheet data shows that WH Smith had liabilities of UK£443.0m due within a year, and liabilities of UK£873.0m falling due after that. On the other hand, it had cash of UK£46.0m and UK£95.0m worth of receivables due within a year. So it has liabilities totalling UK£1.18b more than its cash and near-term receivables, combined.

This deficit isn't so bad because WH Smith is worth UK£1.96b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

WH Smith's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 3.7 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Notably, WH Smith's EBIT launched higher than Elon Musk, gaining a whopping 653% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine WH Smith'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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last two years, WH Smith recorded free cash flow worth a fulsome 90% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

The good news is that WH Smith's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its interest cover. Looking at all the aforementioned factors together, it strikes us that WH Smith can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - WH Smith has 1 warning sign we think you should be aware of.

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. 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.