Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 note that The Estée Lauder Companies Inc. (NYSE:EL) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Estée Lauder Companies's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2020 Estée Lauder Companies had US$6.19b of debt, an increase on US$3.40b, over one year. On the flip side, it has US$4.89b in cash leading to net debt of about US$1.30b.
How Healthy Is Estée Lauder Companies's Balance Sheet?
According to the last reported balance sheet, Estée Lauder Companies had liabilities of US$5.68b due within 12 months, and liabilities of US$8.32b due beyond 12 months. On the other hand, it had cash of US$4.89b and US$1.85b worth of receivables due within a year. So its liabilities total US$7.3b more than the combination of its cash and short-term receivables.
Of course, Estée Lauder Companies has a titanic market capitalization of US$76.4b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
Estée Lauder Companies has a low net debt to EBITDA ratio of only 0.41. And its EBIT covers its interest expense a whopping 29.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. While Estée Lauder Companies doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Estée Lauder Companies 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Estée Lauder Companies produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Estée Lauder Companies's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at the bigger picture, we think Estée Lauder Companies's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider for instance, the ever-present spectre of investment risk. We've identified 4 warning signs with Estée Lauder Companies , and understanding them should be part of your investment process.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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