Pick n Pay Stores (JSE:PIK) Takes On Some Risk With Its Use Of Debt

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.' 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. Importantly, Pick n Pay Stores Limited (JSE:PIK) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Pick n Pay Stores

What Is Pick n Pay Stores's Debt?

The image below, which you can click on for greater detail, shows that at February 2021 Pick n Pay Stores had debt of R5.28b, up from R2.99b in one year. However, its balance sheet shows it holds R5.42b in cash, so it actually has R132.5m net cash.

How Healthy Is Pick n Pay Stores' Balance Sheet?

We can see from the most recent balance sheet that Pick n Pay Stores had liabilities of R20.1b falling due within a year, and liabilities of R14.3b due beyond that. Offsetting this, it had R5.42b in cash and R4.02b in receivables that were due within 12 months. So its liabilities total R25.0b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of R25.1b, so it does suggest shareholders should keep an eye on Pick n Pay Stores' 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, Pick n Pay Stores also has more cash than debt, so we're pretty confident it can manage its debt safely.

Sadly, Pick n Pay Stores's EBIT actually dropped 8.4% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 Pick n Pay Stores 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Pick n Pay Stores 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. During the last three years, Pick n Pay Stores generated free cash flow amounting to a very robust 92% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing up

While Pick n Pay Stores does have more liabilities than liquid assets, it also has net cash of R132.5m. And it impressed us with free cash flow of R3.6b, being 92% of its EBIT. So although we see some areas for improvement, we're not too worried about Pick n Pay Stores's balance sheet. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Pick n Pay Stores (1 can't be ignored) 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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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. 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.
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