David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, adidas AG (ETR:ADS) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is adidas's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 adidas had €2.10b of debt, an increase on €1.23b, over one year. But it also has €2.74b in cash to offset that, meaning it has €639.0m net cash.
How Healthy Is adidas's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that adidas had liabilities of €7.77b due within 12 months and liabilities of €4.89b due beyond that. Offsetting these obligations, it had cash of €2.74b as well as receivables valued at €2.88b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €7.05b.
Of course, adidas has a titanic market capitalization of €54.8b, 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, adidas also has more cash than debt, so we're pretty confident it can manage its debt safely.
Also good is that adidas grew its EBIT at 12% 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 adidas 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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. adidas 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, adidas produced sturdy free cash flow equating to 70% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Although adidas's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of €639.0m. And it impressed us with free cash flow of €2.1b, being 70% of its EBIT. So is adidas's debt a risk? It doesn't seem so to us. Over time, share prices tend to follow earnings per share, so if you're interested in adidas, you may well want to click here to check an interactive graph of its earnings per share history.
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.
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