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. Importantly, Macy’s, Inc. (NYSE:M) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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 step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Macy’s Carry?
The image below, which you can click on for greater detail, shows that Macy’s had debt of US$4.84b at the end of July 2021, a reduction from US$5.39b over a year. On the flip side, it has US$2.14b in cash leading to net debt of about US$2.70b.
A Look At Macy’s’ Liabilities
According to the last reported balance sheet, Macy’s had liabilities of US$6.70b due within 12 months, and liabilities of US$8.57b due beyond 12 months. Offsetting this, it had US$2.14b in cash and US$741.0m in receivables that were due within 12 months. So its liabilities total US$12.4b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$6.73b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Macy’s would probably need a major re-capitalization if its creditors were to demand repayment.
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).
While Macy’s’s low debt to EBITDA ratio of 1.4 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 4.1 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, Macy’s made a loss at the EBIT level, last year, but improved that to positive EBIT of US$1.3b in the last twelve months. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Macy’s can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Macy’s generated free cash flow amounting to a very robust 91% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
Our View
Macy’s’s level of total liabilities and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that Macy’s is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt.