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The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. Importantly, Ralph Lauren Corporation (NYSE:RL) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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 Ralph Lauren's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Ralph Lauren had US$1.63b of debt, an increase on US$695.7m, over one year. But it also has US$2.45b in cash to offset that, meaning it has US$815.1m net cash.
A Look At Ralph Lauren's Liabilities
The latest balance sheet data shows that Ralph Lauren had liabilities of US$1.55b due within a year, and liabilities of US$3.65b falling due after that. Offsetting these obligations, it had cash of US$2.45b as well as receivables valued at US$468.4m due within 12 months. So its liabilities total US$2.29b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Ralph Lauren is worth US$7.89b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. While it does have liabilities worth noting, Ralph Lauren 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 Ralph Lauren if management cannot prevent a repeat of the 77% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Ralph Lauren's ability to maintain a healthy balance sheet going forward. 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. Ralph Lauren 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. Over the last three years, Ralph Lauren recorded free cash flow worth a fulsome 92% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
While Ralph Lauren does have more liabilities than liquid assets, it also has net cash of US$815.1m. And it impressed us with free cash flow of US$344m, being 92% of its EBIT. So we are not troubled with Ralph Lauren's debt use. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we've spotted 2 warning signs for Ralph Lauren (of which 1 is significant!) you should know about.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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