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.' 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. As with many other companies NIKE, Inc. (NYSE:NKE) makes use of debt. 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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

What Is NIKE's Net Debt?

The image below, which you can click on for greater detail, shows that NIKE had debt of US$8.94b at the end of February 2024, a reduction from US$9.44b over a year. However, its balance sheet shows it holds US$10.6b in cash, so it actually has US$1.63b net cash.

How Healthy Is NIKE's Balance Sheet?

We can see from the most recent balance sheet that NIKE had liabilities of US$9.03b falling due within a year, and liabilities of US$14.1b due beyond that. Offsetting these obligations, it had cash of US$10.6b as well as receivables valued at US$4.53b due within 12 months. So its liabilities total US$8.03b more than the combination of its cash and short-term receivables.

Since publicly traded NIKE shares are worth a very impressive total of US$139.1b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, NIKE boasts net cash, so it's fair to say it does not have a heavy debt load!

But the other side of the story is that NIKE saw its EBIT decline by 2.9% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if NIKE 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. NIKE 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. Over the most recent three years, NIKE recorded free cash flow worth 79% 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.

Summing Up

While it is always sensible to look at a company's total liabilities, it is very reassuring that NIKE has US$1.63b in net cash. The cherry on top was that in converted 79% of that EBIT to free cash flow, bringing in US$6.2b. So we don't think NIKE's use of debt is risky. Over time, share prices tend to follow earnings per share, so if you're interested in NIKE, you may well want to click here to check an interactive graph of its earnings per share history.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.