Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Omnicom Group Inc. (NYSE:OMC) does use debt in its business. But the real question is whether this debt is making the company risky.
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Omnicom Group’s Net Debt?
The image below, which you can click on for greater detail, shows that at June 2022 Omnicom Group had debt of US$5.56b, up from US$5.31b in one year. However, it does have US$3.33b in cash offsetting this, leading to net debt of about US$2.24b.
How Healthy Is Omnicom Group’s Balance Sheet?
We can see from the most recent balance sheet that Omnicom Group had liabilities of US$13.2b falling due within a year, and liabilities of US$7.93b due beyond that. Offsetting these obligations, it had cash of US$3.33b as well as receivables valued at US$7.04b due within 12 months. So it has liabilities totalling US$10.8b more than its cash and near-term receivables, combined.
This deficit is considerable relative to its very significant market capitalization of US$13.5b, so it does suggest shareholders should keep an eye on Omnicom Group’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Omnicom Group’s net debt is only 0.95 times its EBITDA. And its EBIT easily covers its interest expense, being 15.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Omnicom Group has increased its EBIT by 9.3% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Omnicom Group can strengthen its balance sheet over time.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Omnicom Group recorded free cash flow worth 75% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Our View
Omnicom Group’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But truth be told we feel its level of total liabilities does undermine this impression a bit. All these things considered, it appears that Omnicom Group can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one.