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. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Ross Stores, Inc. (NASDAQ:ROST) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Ross Stores's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Ross Stores had US$312.8m of debt in November 2019, down from US$397.3m, one year before. But it also has US$1.14b in cash to offset that, meaning it has US$829.9m net cash.
How Strong Is Ross Stores's Balance Sheet?
The latest balance sheet data shows that Ross Stores had liabilities of US$2.86b due within a year, and liabilities of US$3.28b falling due after that. Offsetting this, it had US$1.14b in cash and US$124.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.87b.
Given Ross Stores has a humongous market capitalization of US$43.6b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Ross Stores also has more cash than debt, so we're pretty confident it can manage its debt safely.
While Ross Stores doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. 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 Ross Stores can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. Ross Stores 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, Ross Stores recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Although Ross Stores'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$829.9m. And it impressed us with free cash flow of US$1.5b, being 72% of its EBIT. So we don't think Ross Stores's use of debt is risky. We'd be motivated to research the stock further if we found out that Ross Stores insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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