Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Wm Morrison Supermarkets PLC (LON:MRW) makes use of debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Wm Morrison Supermarkets Carry?
As you can see below, Wm Morrison Supermarkets had UK£1.30b of debt, at February 2019, which is about the same the year before. You can click the chart for greater detail. On the flip side, it has UK£264.0m in cash leading to net debt of about UK£1.03b.
How Strong Is Wm Morrison Supermarkets's Balance Sheet?
The latest balance sheet data shows that Wm Morrison Supermarkets had liabilities of UK£3.30b due within a year, and liabilities of UK£1.99b falling due after that. On the other hand, it had cash of UK£264.0m and UK£211.0m worth of receivables due within a year. So its liabilities total UK£4.81b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's UK£4.56b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Wm Morrison Supermarkets's net debt is only 1.1 times its EBITDA. And its EBIT covers its interest expense a whopping 10.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Wm Morrison Supermarkets grew its EBIT by 4.5% in the last year, making that debt load look even more manageable. 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 Wm Morrison Supermarkets 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Wm Morrison Supermarkets produced sturdy free cash flow equating to 78% 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.
Wm Morrison Supermarkets's conversion of EBIT to free cash flow was a real positive on this analysis, as was its interest cover. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. Looking at all this data makes us feel a little cautious about Wm Morrison Supermarkets's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. We'd be motivated to research the stock further if we found out that Wm Morrison Supermarkets 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.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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