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, JD Sports Fashion plc (LON:JD.) does carry debt. But the more important question is: how much risk is that debt creating?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is JD Sports Fashion's Net Debt?
The image below, which you can click on for greater detail, shows that at August 2019 JD Sports Fashion had debt of UK£228.5m, up from UK£329 in one year. However, its balance sheet shows it holds UK£346.6m in cash, so it actually has UK£118.1m net cash.
How Strong Is JD Sports Fashion's Balance Sheet?
We can see from the most recent balance sheet that JD Sports Fashion had liabilities of UK£1.62b falling due within a year, and liabilities of UK£1.90b due beyond that. Offsetting this, it had UK£346.6m in cash and UK£255.5m in receivables that were due within 12 months. So its liabilities total UK£2.92b more than the combination of its cash and short-term receivables.
JD Sports Fashion has a very large market capitalization of UK£8.26b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, JD Sports Fashion also has more cash than debt, so we're pretty confident it can manage its debt safely.
On top of that, JD Sports Fashion grew its EBIT by 34% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if JD Sports Fashion 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. JD Sports Fashion 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. During the last three years, JD Sports Fashion produced sturdy free cash flow equating to 75% 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.
Although JD Sports Fashion's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£118.1m. And we liked the look of last year's 34% year-on-year EBIT growth. So we don't think JD Sports Fashion's use of debt is risky. 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. Be aware that JD Sports Fashion is showing 1 warning sign in our investment analysis , 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.
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