Warren Buffett famously said, '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. We note that The Warehouse Group Limited (NZSE:WHS) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Warehouse Group's Net Debt?
The image below, which you can click on for greater detail, shows that Warehouse Group had debt of NZ$133.4m at the end of July 2019, a reduction from NZ$192.2m over a year. However, because it has a cash reserve of NZ$50.2m, its net debt is less, at about NZ$83.2m.
How Strong Is Warehouse Group's Balance Sheet?
According to the last reported balance sheet, Warehouse Group had liabilities of NZ$540.5m due within 12 months, and liabilities of NZ$28.3m due beyond 12 months. Offsetting these obligations, it had cash of NZ$50.2m as well as receivables valued at NZ$77.2m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$441.4m.
This deficit isn't so bad because Warehouse Group is worth NZ$1.01b, 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.
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.
Warehouse Group has a low net debt to EBITDA ratio of only 0.51. And its EBIT covers its interest expense a whopping 12.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Warehouse Group has been able to increase its EBIT by 24% in twelve months, making it easier to pay down 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 Warehouse Group 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Warehouse Group produced sturdy free cash flow equating to 74% 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.
The good news is that Warehouse Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. Looking at the bigger picture, we think Warehouse Group's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. Given Warehouse Group has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.