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 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. We can see that NIKE, Inc. (NYSE:NKE) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is NIKE’s Debt?
The image below, which you can click on for greater detail, shows that at February 2021 NIKE had debt of US$9.42b, up from US$3.48b in one year. But it also has US$12.5b in cash to offset that, meaning it has US$3.11b net cash.
How Healthy Is NIKE’s Balance Sheet?
The latest balance sheet data shows that NIKE had liabilities of US$8.89b due within a year, and liabilities of US$15.4b falling due after that. Offsetting this, it had US$12.5b in cash and US$3.67b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$8.06b.
Given NIKE has a humongous market capitalization of US$211.6b, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, NIKE also has more cash than debt, so we’re pretty confident it can manage its debt safely.
But the bad news is that NIKE has seen its EBIT plunge 15% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine NIKE’s ability to maintain a healthy balance sheet going forward.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While NIKE 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. During the last three years, NIKE generated free cash flow amounting to a very robust 85% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
We could understand if investors are concerned about NIKE’s liabilities, but we can be reassured by the fact it has has net cash of US$3.11b. And it impressed us with free cash flow of US$3.8b, being 85% of its EBIT. So we are not troubled with NIKE’s debt use. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it.