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Wesfarmers (ASX:WES) Seems To Use Debt Quite Sensibly

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.' 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. We note that Wesfarmers Limited (ASX:WES) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Wesfarmers

How Much Debt Does Wesfarmers Carry?

As you can see below, Wesfarmers had AU$2.66b of debt at June 2020, down from AU$3.03b a year prior. However, its balance sheet shows it holds AU$2.91b in cash, so it actually has AU$257.0m net cash.

debt-equity-history-analysis
debt-equity-history-analysis

How Strong Is Wesfarmers's Balance Sheet?

The latest balance sheet data shows that Wesfarmers had liabilities of AU$7.27b due within a year, and liabilities of AU$8.81b falling due after that. Offsetting this, it had AU$2.91b in cash and AU$1.04b in receivables that were due within 12 months. So it has liabilities totalling AU$12.1b more than its cash and near-term receivables, combined.

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This deficit isn't so bad because Wesfarmers is worth a massive AU$56.3b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Wesfarmers also has more cash than debt, so we're pretty confident it can manage its debt safely.

Also good is that Wesfarmers grew its EBIT at 11% over the last year, further increasing its ability to manage debt. 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 Wesfarmers 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. Wesfarmers 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, Wesfarmers generated free cash flow amounting to a very robust 93% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing up

Although Wesfarmers's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$257.0m. The cherry on top was that in converted 93% of that EBIT to free cash flow, bringing in AU$3.7b. So we don't think Wesfarmers's use of debt is risky. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for Wesfarmers you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

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