David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Tiffany & Co. (NYSE:TIF) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Tiffany Carry?
The image below, which you can click on for greater detail, shows that at July 2019 Tiffany had debt of US$1.02b, up from US$971.7m in one year. However, it also had US$680.6m in cash, and so its net debt is US$338.6m.
How Strong Is Tiffany's Balance Sheet?
The latest balance sheet data shows that Tiffany had liabilities of US$871.1m due within a year, and liabilities of US$2.25b falling due after that. On the other hand, it had cash of US$680.6m and US$241.0m worth of receivables due within a year. So its liabilities total US$2.20b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Tiffany has a huge market capitalization of US$10.7b, 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.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Tiffany's net debt is only 0.35 times its EBITDA. And its EBIT easily covers its interest expense, being 18.1 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Tiffany's EBIT dived 15%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Tiffany'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Tiffany produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
On our analysis Tiffany's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. To be specific, it seems about as good at (not) growing its EBIT as wet socks are at keeping your feet warm. When we consider all the elements mentioned above, it seems to us that Tiffany is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. We'd be motivated to research the stock further if we found out that Tiffany insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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