Is Watches of Switzerland Group (LON:WOSG) 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.' 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. We note that Watches of Switzerland Group plc (LON:WOSG) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Watches of Switzerland Group

How Much Debt Does Watches of Switzerland Group Carry?

As you can see below, Watches of Switzerland Group had UK£118.6m of debt, at May 2022, 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£105.9m, its net debt is less, at about UK£12.7m.

A Look At Watches of Switzerland Group's Liabilities

We can see from the most recent balance sheet that Watches of Switzerland Group had liabilities of UK£249.8m falling due within a year, and liabilities of UK£418.9m due beyond that. Offsetting this, it had UK£105.9m in cash and UK£20.2m in receivables that were due within 12 months. So its liabilities total UK£542.6m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Watches of Switzerland Group has a market capitalization of UK£1.83b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. But either way, Watches of Switzerland Group has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Watches of Switzerland Group has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.073 and EBIT of 11.8 times the interest expense. So relative to past earnings, the debt load seems trivial. On top of that, Watches of Switzerland Group grew its EBIT by 56% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Watches of Switzerland Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Watches of Switzerland Group actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that Watches of Switzerland Group's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Overall, we don't think Watches of Switzerland Group is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. We'd be very excited to see if Watches of Switzerland Group insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.

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.