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.’ 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, Levi Strauss & Co. (NYSE:LEVI) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Levi Strauss’s Debt?
The image below, which you can click on for greater detail, shows that at February 2021 Levi Strauss had debt of US$2.06b, up from US$1.01b in one year. But on the other hand it also has US$2.07b in cash, leading to a US$7.83m net cash position.
A Look At Levi Strauss’ Liabilities
Zooming in on the latest balance sheet data, we can see that Levi Strauss had liabilities of US$2.32b due within 12 months and liabilities of US$2.51b due beyond that. Offsetting this, it had US$2.07b in cash and US$600.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.16b.
Of course, Levi Strauss has a titanic market capitalization of US$11.1b, so these liabilities are probably manageable. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Levi Strauss also has more cash than debt, so we’re pretty confident it can manage its debt safely.
Shareholders should be aware that Levi Strauss’s EBIT was down 70% 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 Levi Strauss can strengthen its balance sheet over time.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. Levi Strauss 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. Over the most recent three years, Levi Strauss recorded free cash flow worth 66% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Although Levi Strauss’s balance sheet isn’t particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$7.83m. The cherry on top was that in converted 66% of that EBIT to free cash flow, bringing in US$218m. So although we see some areas for improvement, we’re not too worried about Levi Strauss’s balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt.