David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that The Warehouse Group Limited (NZSE:WHS) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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, 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.
How Much Debt Does Warehouse Group Carry?
As you can see below, Warehouse Group had NZ$27.1m of debt at August 2020, down from NZ$133.4m a year prior. However, it does have NZ$168.1m in cash offsetting this, leading to net cash of NZ$141.0m.
How Healthy Is Warehouse Group's Balance Sheet?
According to the last reported balance sheet, Warehouse Group had liabilities of NZ$626.3m due within 12 months, and liabilities of NZ$852.2m due beyond 12 months. On the other hand, it had cash of NZ$168.1m and NZ$84.3m worth of receivables due within a year. So it has liabilities totalling NZ$1.23b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the NZ$797.6m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Warehouse Group would probably need a major re-capitalization if its creditors were to demand repayment. Given that Warehouse Group has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
It is well worth noting that Warehouse Group's EBIT shot up like bamboo after rain, gaining 38% in the last twelve months. That'll make it easier to manage 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 Warehouse Group 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. Warehouse Group 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. Happily for any shareholders, Warehouse Group 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.
While Warehouse Group does have more liabilities than liquid assets, it also has net cash of NZ$141.0m. The cherry on top was that in converted 143% of that EBIT to free cash flow, bringing in NZ$343m. So we are not troubled with Warehouse Group's debt use. 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. Consider risks, for instance. Every company has them, and we've spotted 2 warning signs for Warehouse Group you should know about.
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.
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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