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.’ 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. As with many other companies Signet Jewelers Limited (NYSE:SIG) makes use of debt. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. 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 examine debt levels, we first consider both cash and debt levels, together.
What Is Signet Jewelers’s Net Debt?
The image below, which you can click on for greater detail, shows that Signet Jewelers had debt of US$146.7m at the end of January 2021, a reduction from US$611.5m over a year. However, it does have US$1.17b in cash offsetting this, leading to net cash of US$1.03b.
A Look At Signet Jewelers’ Liabilities
The latest balance sheet data shows that Signet Jewelers had liabilities of US$2.00b due within a year, and liabilities of US$2.35b falling due after that. On the other hand, it had cash of US$1.17b and US$135.3m worth of receivables due within a year. So its liabilities total US$3.04b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$3.32b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, Signet Jewelers boasts net cash, so it’s fair to say it does not have a heavy debt load!
Shareholders should be aware that Signet Jewelers’s EBIT was down 53% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Signet Jewelers can strengthen its balance sheet over time.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Signet Jewelers 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. Over the last three years, Signet Jewelers actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
While Signet Jewelers does have more liabilities than liquid assets, it also has net cash of US$1.03b. The cherry on top was that in converted 316% of that EBIT to free cash flow, bringing in US$1.3b. So although we see some areas for improvement, we’re not too worried about Signet Jewelers’s balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet.