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'. 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. Importantly, Myer Holdings Limited (ASX:MYR) does carry debt. But the more important question is: how much risk is that debt creating?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Myer Holdings's Net Debt?
As you can see below, Myer Holdings had AU$77.4m of debt at January 2020, down from AU$95.4m a year prior. However, it does have AU$180.3m in cash offsetting this, leading to net cash of AU$102.9m.
How Strong Is Myer Holdings's Balance Sheet?
According to the last reported balance sheet, Myer Holdings had liabilities of AU$668.4m due within 12 months, and liabilities of AU$1.77b due beyond 12 months. On the other hand, it had cash of AU$180.3m and AU$26.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$2.24b.
This deficit casts a shadow over the AU$168.1m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Myer Holdings would probably need a major re-capitalization if its creditors were to demand repayment. Myer Holdings boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.
It is well worth noting that Myer Holdings's EBIT shot up like bamboo after rain, gaining 76% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Myer Holdings'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. While Myer Holdings 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, Myer Holdings generated free cash flow amounting to a very robust 86% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Although Myer Holdings's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$102.9m. And it impressed us with free cash flow of AU$136m, being 86% of its EBIT. So we don't have any problem with Myer Holdings's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 3 warning signs for Myer Holdings 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.
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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