Is Children's Place (NASDAQ:PLCE) A Risky Investment?

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 note that The Children's Place, Inc. (NASDAQ:PLCE) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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.

View our latest analysis for Children's Place

What Is Children's Place's Net Debt?

The image below, which you can click on for greater detail, shows that at October 2022 Children's Place had debt of US$314.7m, up from US$251.5m in one year. However, it does have US$19.2m in cash offsetting this, leading to net debt of about US$295.5m.

How Strong Is Children's Place's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Children's Place had liabilities of US$683.7m due within 12 months and liabilities of US$188.8m due beyond that. Offsetting this, it had US$19.2m in cash and US$67.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$785.3m.

This deficit casts a shadow over the US$492.9m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Children's Place would likely require a major re-capitalisation if it had to pay its creditors today.

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.

With a debt to EBITDA ratio of 1.6, Children's Place uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.4 times its interest expenses harmonizes with that theme. In fact Children's Place's saving grace is its low debt levels, because its EBIT has tanked 48% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Children's Place's ability to maintain a healthy balance sheet going forward. 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 always check how much of that EBIT is translated into free cash flow. Over the last two years, Children's Place reported free cash flow worth 17% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

To be frank both Children's Place's level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Taking into account all the aforementioned factors, it looks like Children's Place has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Children's Place you should be aware of, and 1 of them doesn't sit too well with us.

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.