We think adidas (ETR:ADS) can stay on top of their debt

Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. Like many other companies adidas S.A. (ETR:ADS) uses debt. But does this debt worry shareholders?

What risk does debt carry?

Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. In the worst case, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. When we look at debt levels, we first consider cash and debt levels, together.

See our latest review for adidas

What is adidas Net Debt?

As you can see below, adidas had 2.77 billion euros in debt in June 2022, compared to 3.16 billion euros the previous year. On the other hand, he has €1.66 billion in cash, which results in a net debt of around €1.12 billion.

XTRA:ADS Debt to Equity September 11, 2022

How strong is adidas’ balance sheet?

The latest balance sheet data shows that adidas had liabilities of 9.60 billion euros due within one year, and liabilities of 5.30 billion euros falling due thereafter. In compensation for these obligations, it had cash of 1.66 billion euros as well as receivables worth 3.12 billion euros at less than 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by €10.1 billion.

This shortfall isn’t that bad as adidas is worth €26.4 billion and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. However, it is always worth taking a close look at its ability to repay debt.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). Thus, we consider debt to earnings with and without amortization and depreciation expense.

adidas has a low net debt to EBITDA ratio of just 0.51. And its EBIT easily covers its interest charges, being 10.7 times higher. One could therefore say that he is no more threatened by his debt than an elephant is by a mouse. Its low leverage may become crucial for adidas if management cannot prevent a repeat of the 29% reduction in EBIT over the past year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether adidas can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

Finally, a company can only repay its debts with cold hard cash, not with book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, adidas has recorded free cash flow of 88% of its EBIT, which is higher than we would normally expect. This positions him well to pay off debt if desired.

Our point of view

From what we’ve seen, adidas doesn’t find it easy given its EBIT growth rate, but the other factors we’ve considered give us cause for optimism. In particular, we are blown away by its conversion of EBIT to free cash flow. Given this range of data points, we believe adidas is in a good position to manage its level of leverage. That said, the charge is heavy enough that we recommend that any shareholder keep a close eye on it. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. To this end, you should be aware of the 1 warning sign we spotted with adidas.

Of course, if you’re the type of investor who prefers to buy stocks without the burden of debt, then feel free to check out our exclusive list of cash-efficient growth stocks today.

This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.

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