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.' 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 Dillard's, Inc. (NYSE:DDS) makes use of debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Dillard's's Debt?
The image below, which you can click on for greater detail, shows that Dillard's had debt of US$565.6m at the end of May 2019, a reduction from US$730.1m over a year. However, it does have US$139.8m in cash offsetting this, leading to net debt of about US$425.8m.
How Strong Is Dillard's's Balance Sheet?
The latest balance sheet data shows that Dillard's had liabilities of US$1.18b due within a year, and liabilities of US$862.7m falling due after that. Offsetting this, it had US$139.8m in cash and US$47.9m in receivables that were due within 12 months. So its liabilities total US$1.85b more than the combination of its cash and short-term receivables.
Given this deficit is actually higher than the company's market capitalization of US$1.54b, we think shareholders really should watch Dillard's's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Looking at its net debt to EBITDA of 0.91 and interest cover of 5.5 times, it seems to us that Dillard's is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Sadly, Dillard's's EBIT actually dropped 8.4% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Dillard's's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Dillard's recorded free cash flow worth a fulsome 98% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
Dillard's's level of total liabilities and EBIT growth rate definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Dillard's's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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