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Is American Eagle Outfitters (NYSE:AEO) A Risky Investment?

Simply Wall St

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. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that American Eagle Outfitters, Inc. (NYSE:AEO) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for American Eagle Outfitters

What Is American Eagle Outfitters's Debt?

As you can see below, at the end of May 2020, American Eagle Outfitters had US$643.0m of debt, up from none a year ago. Click the image for more detail. But it also has US$885.7m in cash to offset that, meaning it has US$242.8m net cash.

NYSE:AEO Historical Debt June 18th 2020
NYSE:AEO Historical Debt June 18th 2020

How Strong Is American Eagle Outfitters's Balance Sheet?

The latest balance sheet data shows that American Eagle Outfitters had liabilities of US$662.2m due within a year, and liabilities of US$1.97b falling due after that. Offsetting this, it had US$885.7m in cash and US$106.8m in receivables that were due within 12 months. So it has liabilities totalling US$1.64b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$1.98b, so it does suggest shareholders should keep an eye on American Eagle Outfitters's 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, American Eagle Outfitters also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for American Eagle Outfitters if management cannot prevent a repeat of the 80% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if American Eagle Outfitters 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. While American Eagle Outfitters 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, American Eagle Outfitters produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

Although American Eagle Outfitters'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$242.8m. So although we see some areas for improvement, we're not too worried about American Eagle Outfitters's balance sheet. 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. Be aware that American Eagle Outfitters is showing 3 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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.

Love or hate this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.

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. Thank you for reading.