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 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 can see that Qurate Retail, Inc. (NASDAQ:QRTE.A) does use debt in its business. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Qurate Retail Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2021 Qurate Retail had US$8.55b of debt, an increase on US$8.11b, over one year. However, because it has a cash reserve of US$798.0m, its net debt is less, at about US$7.76b.
A Look At Qurate Retail’s Liabilities
We can see from the most recent balance sheet that Qurate Retail had liabilities of US$4.45b falling due within a year, and liabilities of US$8.60b due beyond that. On the other hand, it had cash of US$798.0m and US$1.19b worth of receivables due within a year. So it has liabilities totalling US$11.1b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$2.72b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Qurate Retail would probably need a major re-capitalization if its creditors were to demand repayment.
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.
Qurate Retail has a debt to EBITDA ratio of 3.6 and its EBIT covered its interest expense 3.4 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. The good news is that Qurate Retail improved its EBIT by 9.1% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. 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 Qurate Retail’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. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Qurate Retail recorded free cash flow worth 78% 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.
Mulling over Qurate Retail’s attempt at staying on top of its total liabilities, we’re certainly not enthusiastic. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Qurate Retail stock a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start.