Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Signet Jewelers Limited (NYSE:SIG) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Signet Jewelers's Net Debt?
As you can see below, Signet Jewelers had US$146.8m of debt at May 2021, down from US$1.36b a year prior. But on the other hand it also has US$1.30b in cash, leading to a US$1.15b net cash position.
How Healthy Is Signet Jewelers' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Signet Jewelers had liabilities of US$1.90b due within 12 months and liabilities of US$2.31b due beyond that. On the other hand, it had cash of US$1.30b and US$129.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.78b.
This deficit is considerable relative to its market capitalization of US$3.90b, so it does suggest shareholders should keep an eye on Signet Jewelers' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, Signet Jewelers also has more cash than debt, so we're pretty confident it can manage its debt safely.
Better yet, Signet Jewelers grew its EBIT by 181% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Signet Jewelers'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 Signet Jewelers 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. Over the last three years, Signet Jewelers actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Although Signet Jewelers'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$1.15b. And it impressed us with free cash flow of US$1.5b, being 275% of its EBIT. So we don't think Signet Jewelers's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 2 warning signs for Signet Jewelers you should be aware of, and 1 of them is significant.
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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