We Think Southwest Airlines (NYSE:LUV) Is Taking Some Risk With Its Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Southwest Airlines Co. (NYSE:LUV) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Southwest Airlines

What Is Southwest Airlines's Net Debt?

As you can see below, Southwest Airlines had US$7.90b of debt at December 2022, down from US$10.3b a year prior. However, its balance sheet shows it holds US$12.3b in cash, so it actually has US$4.39b net cash.

A Look At Southwest Airlines' Liabilities

We can see from the most recent balance sheet that Southwest Airlines had liabilities of US$10.4b falling due within a year, and liabilities of US$14.3b due beyond that. Offsetting this, it had US$12.3b in cash and US$1.01b in receivables that were due within 12 months. So it has liabilities totalling US$11.4b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Southwest Airlines is worth a massive US$20.7b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, Southwest Airlines boasts net cash, so it's fair to say it does not have a heavy debt load!

Although Southwest Airlines made a loss at the EBIT level, last year, it was also good to see that it generated US$1.1b in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Southwest Airlines can strengthen its balance sheet over time. 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. Southwest Airlines may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last year, Southwest Airlines recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Summing Up

Although Southwest Airlines'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$4.39b. So while Southwest Airlines does not have a great balance sheet, it's certainly not too bad. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Southwest Airlines you should be aware of.

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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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.