Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that The Kroger Co. (NYSE:KR) does use debt in its business. But is this debt a concern to shareholders?
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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Kroger's Net Debt?
The chart below, which you can click on for greater detail, shows that Kroger had US$12.6b in debt in November 2020; about the same as the year before. On the flip side, it has US$2.18b in cash leading to net debt of about US$10.4b.
How Strong Is Kroger's Balance Sheet?
We can see from the most recent balance sheet that Kroger had liabilities of US$15.5b falling due within a year, and liabilities of US$22.9b due beyond that. On the other hand, it had cash of US$2.18b and US$1.61b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$34.6b.
When you consider that this deficiency exceeds the company's huge US$25.8b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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).
Kroger's net debt is sitting at a very reasonable 1.6 times its EBITDA, while its EBIT covered its interest expense just 6.5 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. On top of that, Kroger grew its EBIT by 52% over the last twelve months, and that growth will make it easier to handle its debt. 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 Kroger can strengthen its balance sheet over time. 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Kroger produced sturdy free cash flow equating to 72% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Both Kroger's ability to to grow its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. But truth be told its level of total liabilities had us nibbling our nails. Looking at all this data makes us feel a little cautious about Kroger's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 Kroger has 4 warning signs (and 1 which is a bit concerning) we think 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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