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Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. DICK’S Sporting Goods, Inc. (NYSE:DKS) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does DICK’S Sporting Goods Carry?
The image below, which you can click on for greater detail, shows that at May 2019 DICK’S Sporting Goods had debt of US$369.5m, up from US$344.1m in one year. On the flip side, it has US$92.4m in cash leading to net debt of about US$277.1m.
A Look At DICK’S Sporting Goods’s Liabilities
According to the last reported balance sheet, DICK’S Sporting Goods had liabilities of US$1.86b due within 12 months, and liabilities of US$3.23b due beyond 12 months. Offsetting these obligations, it had cash of US$92.4m as well as receivables valued at US$56.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.94b.
Given this deficit is actually higher than the company’s market capitalization of US$3.31b, we think shareholders really should watch DICK’S Sporting Goods’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Since DICK’S Sporting Goods does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
DICK’S Sporting Goods has a low net debt to EBITDA ratio of only 0.40. And its EBIT easily covers its interest expense, being 41.3 times the size. So we’re pretty relaxed about its super-conservative use of debt. On the other hand, DICK’S Sporting Goods’s EBIT dived 10%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine DICK’S Sporting Goods’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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, DICK’S Sporting Goods recorded free cash flow worth 64% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Mulling over DICK’S Sporting Goods’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that DICK’S Sporting Goods’s debt is making it a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check DICK’S Sporting Goods’s dividend history, without delay!
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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If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.