Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Vipshop Holdings Limited (NYSE:VIPS) makes use of debt. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Vipshop Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2020 Vipshop Holdings had debt of CN¥2.23b, up from CN¥1.88b in one year. However, it does have CN¥13.8b in cash offsetting this, leading to net cash of CN¥11.6b.
A Look At Vipshop Holdings' Liabilities
We can see from the most recent balance sheet that Vipshop Holdings had liabilities of CN¥22.4b falling due within a year, and liabilities of CN¥3.21b due beyond that. On the other hand, it had cash of CN¥13.8b and CN¥3.13b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CN¥8.63b.
Of course, Vipshop Holdings has a titanic market capitalization of CN¥128.5b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Vipshop Holdings also has more cash than debt, so we're pretty confident it can manage its debt safely.
On top of that, Vipshop Holdings grew its EBIT by 50% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Vipshop Holdings 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 company can only pay off debt with cold hard cash, not accounting profits. While Vipshop Holdings 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 most recent three years, Vipshop Holdings recorded free cash flow worth 65% 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.
We could understand if investors are concerned about Vipshop Holdings's liabilities, but we can be reassured by the fact it has has net cash of CN¥11.6b. And we liked the look of last year's 50% year-on-year EBIT growth. So is Vipshop Holdings's debt a risk? It doesn't seem so to us. 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 instance, we've identified 1 warning sign for Vipshop Holdings that you should be aware of.
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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