Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, The Estée Lauder Companies Inc. (NYSE:EL) does carry debt. But is this debt a concern to shareholders?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

How Much Debt Does Estée Lauder Companies Carry?

As you can see below, Estée Lauder Companies had US$7.77b of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$3.70b in cash leading to net debt of about US$4.07b.

A Look At Estée Lauder Companies' Liabilities

The latest balance sheet data shows that Estée Lauder Companies had liabilities of US$5.42b due within a year, and liabilities of US$10.7b falling due after that. On the other hand, it had cash of US$3.70b and US$1.85b worth of receivables due within a year. So it has liabilities totalling US$10.6b more than its cash and near-term receivables, combined.

Estée Lauder Companies has a very large market capitalization of US$43.2b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

Estée Lauder Companies's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 6.1 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Importantly, Estée Lauder Companies's EBIT fell a jaw-dropping 32% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Estée Lauder Companies 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Estée Lauder Companies recorded free cash flow of 27% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Estée Lauder Companies's attempt at (not) growing its EBIT, we're certainly not enthusiastic. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. Once we consider all the factors above, together, it seems to us that Estée Lauder Companies's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for Estée Lauder Companies (1 shouldn't be ignored!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.