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 Guess', Inc. (NYSE:GES) does use debt in its business. But should shareholders be worried about its use of debt?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Guess''s Debt?
You can click the graphic below for the historical numbers, but it shows that as of October 2020 Guess' had US$338.9m of debt, an increase on US$299.8m, over one year. However, its balance sheet shows it holds US$365.3m in cash, so it actually has US$26.4m net cash.
How Strong Is Guess''s Balance Sheet?
We can see from the most recent balance sheet that Guess' had liabilities of US$735.4m falling due within a year, and liabilities of US$1.16b due beyond that. Offsetting this, it had US$365.3m in cash and US$300.4m in receivables that were due within 12 months. So its liabilities total US$1.23b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$1.53b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, Guess' boasts net cash, so it's fair to say it does not have a heavy debt load!
Importantly, Guess''s EBIT fell a jaw-dropping 44% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Guess''s ability to maintain a healthy balance sheet going forward. 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 company can only pay off debt with cold hard cash, not accounting profits. While Guess' has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Guess' actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Although Guess''s balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$26.4m. And it impressed us with free cash flow of US$299m, being 117% of its EBIT. So while Guess' does not have a great balance sheet, it's certainly not too bad. 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. For example Guess' has 3 warning signs (and 1 which shouldn't be ignored) we think you should know about.
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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