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. As with many other companies Dillard’s, Inc. (NYSE:DDS) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is Dillard’s’s Debt?

The chart below, which you can click on for greater detail, shows that Dillard’s had US$565.8m in debt in January 2021; about the same as the year before. On the flip side, it has US$360.3m in cash leading to net debt of about US$205.5m.

How Healthy Is Dillard’s’ Balance Sheet?

The latest balance sheet data shows that Dillard’s had liabilities of US$772.9m due within a year, and liabilities of US$878.6m falling due after that. Offsetting these obligations, it had cash of US$360.3m as well as receivables valued at US$155.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.14b.

This deficit isn’t so bad because Dillard’s is worth US$2.21b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Dillard’s can strengthen its balance sheet over time.

Caveat Emptor

While Dillard’s’s falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. To be specific the EBIT loss came in at US$91m. When we look at that and recall the liabilities on its balance sheet, relative to cash, it seems unwise to us for the company to have any debt. So we think its balance sheet is a little strained, though not beyond repair. For example, we would not want to see a repeat of last year’s loss of US$72m. So in short it’s a really risky stock. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it.