Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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. We note that Unilever PLC (LON:ULVR) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
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What Is Unilever‘s Debt?
The chart below, which you can click on for greater detail, shows that Unilever had €25.5b in debt in December 2020; about the same as the year before. However, it does have €6.51b in cash offsetting this, leading to net debt of about €19.0b.
How Strong Is Unilever‘s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Unilever had liabilities of €20.6b due within 12 months and liabilities of €29.4b due beyond that. Offsetting this, it had €6.51b in cash and €4.37b in receivables that were due within 12 months. So its liabilities total €39.1b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Unilever has a huge market capitalization of €125.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
We’d say that Unilever‘s moderate net debt to EBITDA ratio ( being 1.8), indicates prudence when it comes to debt. And its strong interest cover of 20.9 times, makes us even more comfortable. Unfortunately, Unilever saw its EBIT slide 5.6% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Unilever 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. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Unilever recorded free cash flow worth 71% 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.
Happily, Unilever‘s impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its EBIT growth rate does undermine this impression a bit. All these things considered, it appears that Unilever can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We’ve identified 2 warning signs with Unilever , and understanding them should be part of your investment process.
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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