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 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 Qurate Retail, Inc. (NASDAQ:QRTE.A) does have debt on its balance sheet. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do not see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering the company’s debt levels is to consider its cash and debt together.
How Much Debt Does Qurate Retail Carry?
As you can see below, Qurate Retail had US$7.73b of debt at June 2022, down from US$8.45ba year prior. However, it does have US$561.0m in cash offsetting this, leading to net debt of about US$7.17b.
How Strong Is Qurate Retail’s Balance Sheet?
We can see from the most recent balance sheet that Qurate Retail had liabilities of US$3.37b falling due within a year, and liabilities of US$8.66b due beyond that. Offsetting these obligations, it had cash of US$561.0m as well as receivables valued at US$1.14b due within 12 months. So it has liabilities totaling US$10.3b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$1.25b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we’d watch its balance sheet closely, without a doubt. After all, Qurate Retail would likely require a major re-capitalization if it had to pay its creditors today.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Qurate Retail’s debt to EBITDA ratio (4.5) suggests that it uses some debt, its interest cover is very weak, at 2.2, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, late. Worse, Qurate Retail’s EBIT was down 40% over the last year. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analyzing debt. But ultimately the future profitability of the business will decide if Qurate Retail 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, 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, Qurate Retail recorded free cash flow worth 79% 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.
To be frank both Qurate Retail’s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, it seems to us that Qurate Retail’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analyzing 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. Case in point: We’ve spotted 3 warning signs for Qurate Retail you should be aware of, and 1 of them is significant.
When all is said and done, sometimes it’s easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% freeright now.
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