These 4 Measures Indicate That Watches of Switzerland Group (LON:WOSG) Is Using Debt Safely

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Watches of Switzerland Group plc (LON:WOSG) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Watches of Switzerland Group

How Much Debt Does Watches of Switzerland Group Carry?

You can click the graphic below for the historical numbers, but it shows that as of October 2022 Watches of Switzerland Group had UK£136.2m of debt, an increase on UK£118.3m, over one year. However, because it has a cash reserve of UK£111.6m, its net debt is less, at about UK£24.6m.

A Look At Watches of Switzerland Group's Liabilities

According to the last reported balance sheet, Watches of Switzerland Group had liabilities of UK£309.8m due within 12 months, and liabilities of UK£481.7m due beyond 12 months. Offsetting these obligations, it had cash of UK£111.6m as well as receivables valued at UK£21.1m due within 12 months. So its liabilities total UK£658.8m more than the combination of its cash and short-term receivables.

Watches of Switzerland Group has a market capitalization of UK£2.39b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Watches of Switzerland Group has net debt of just 0.13 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.7 times the interest expense over the last year. Another good sign is that Watches of Switzerland Group has been able to increase its EBIT by 29% in twelve months, making it easier to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Watches of Switzerland Group'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Watches of Switzerland Group generated free cash flow amounting to a very robust 94% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Watches of Switzerland Group's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its EBIT growth rate also supports that impression! Overall, we don't think Watches of Switzerland Group is taking any bad risks, as its debt load seems modest. So we're not worried about the use of a little leverage on the balance sheet. Another factor that would give us confidence in Watches of Switzerland Group would be if insiders have been buying shares: if you're conscious of that signal too, you can find out instantly by clicking this link.

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.