The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that The Estée Lauder Companies Inc. (NYSE:EL) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 Estée Lauder Companies Carry?

The chart below, which you can click on for greater detail, shows that Estée Lauder Companies had US$5.96b in debt in March 2021; about the same as the year before. However, it does have US$6.41b in cash offsetting this, leading to net cash of US$448.0m.

How Healthy Is Estée Lauder Companies’ Balance Sheet?

The latest balance sheet data shows that Estée Lauder Companies had liabilities of US$5.20b due within a year, and liabilities of US$9.15b falling due after that. On the other hand, it had cash of US$6.41b and US$1.74b worth of receivables due within a year. So it has liabilities totalling US$6.20b more than its cash and near-term receivables, combined.

Given Estée Lauder Companies has a humongous market capitalization of US$119.2b, it’s hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Despite its noteworthy liabilities, Estée Lauder Companies boasts net cash, so it’s fair to say it does not have a heavy debt load!

On the other hand, Estée Lauder Companies saw its EBIT drop by 2.2% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Estée Lauder Companies’s ability to maintain a healthy balance sheet going forward.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Estée Lauder Companies may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Estée Lauder Companies generated free cash flow amounting to a very robust 81% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.

Summing up

We could understand if investors are concerned about Estée Lauder Companies’s liabilities, but we can be reassured by the fact it has has net cash of US$448.0m. And it impressed us with free cash flow of US$2.6b, being 81% of its EBIT. So we don’t think Estée Lauder Companies’s use of debt is risky. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet.