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. We can see that BJ's Wholesale Club Holdings, Inc. (NYSE:BJ) does use debt in its business. But the more important question is: how much risk is that debt creating?
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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is BJ's Wholesale Club Holdings's Debt?
The image below, which you can click on for greater detail, shows that BJ's Wholesale Club Holdings had debt of US$829.0m at the end of April 2022, a reduction from US$977.5m over a year. However, it does have US$38.0m in cash offsetting this, leading to net debt of about US$791.0m.
How Healthy Is BJ's Wholesale Club Holdings' Balance Sheet?
We can see from the most recent balance sheet that BJ's Wholesale Club Holdings had liabilities of US$2.21b falling due within a year, and liabilities of US$3.08b due beyond that. Offsetting these obligations, it had cash of US$38.0m as well as receivables valued at US$210.4m due within 12 months. So its liabilities total US$5.04b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since BJ's Wholesale Club Holdings has a market capitalization of US$9.21b, 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.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
BJ's Wholesale Club Holdings's net debt is only 0.94 times its EBITDA. And its EBIT easily covers its interest expense, being 13.9 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, BJ's Wholesale Club Holdings grew its EBIT by 5.2% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if BJ's Wholesale Club Holdings 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, BJ's Wholesale Club Holdings recorded free cash flow worth 73% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
BJ's Wholesale Club Holdings's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its level of total liabilities does undermine this impression a bit. All these things considered, it appears that BJ's Wholesale Club Holdings can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - BJ's Wholesale Club Holdings has 2 warning signs we think 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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