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.' 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 Urban Outfitters, Inc. (NASDAQ:URBN) makes use of debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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 Urban Outfitters's Debt?
You can click the graphic below for the historical numbers, but it shows that as of July 2020 Urban Outfitters had US$120.0m of debt, an increase on none, over one year. However, it does have US$663.4m in cash offsetting this, leading to net cash of US$543.4m.
How Healthy Is Urban Outfitters's Balance Sheet?
According to the last reported balance sheet, Urban Outfitters had liabilities of US$771.2m due within 12 months, and liabilities of US$1.30b due beyond 12 months. On the other hand, it had cash of US$663.4m and US$60.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.35b.
While this might seem like a lot, it is not so bad since Urban Outfitters has a market capitalization of US$2.37b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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, Urban 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 Urban Outfitters if management cannot prevent a repeat of the 92% 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Urban Outfitters can strengthen its balance sheet over time. 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 Urban 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. Over the last three years, Urban Outfitters recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
Although Urban 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$543.4m. The cherry on top was that in converted 81% of that EBIT to free cash flow, bringing in US$155m. So we are not troubled with Urban Outfitters's debt use. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Urban Outfitters that you should be aware of before investing here.
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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