Is L’Oréal (EPA: OR) a risky investment?
David Iben put it right when he said: “Volatility is not a risk that is close to our hearts. What matters to us is to avoid the permanent loss of capital. It is natural to consider a company’s balance sheet when considering how risky it is, as debt is often involved when a business collapses. We can see that L’Oreal SA (EPA: OR) uses debt in its business. But the real question is whether this debt makes the business risky.
When is debt a problem?
Debt and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. While it’s not too common, we often see indebted companies continually diluting shareholders because lenders are forcing them to raise capital at a difficult price. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
Check out our latest analysis for L’Oréal
What is L’Oréal’s net debt?
The graph below, which you can click for more details, shows that L’Oréal had € 864.9m in debt in December 2020; about the same as the year before. However, his balance sheet shows that he has 6.41 billion euros in cash, so in reality 5.55 billion euros in net cash.
How strong is L’Oréal’s balance sheet?
We can see from the most recent balance sheet that L’Oréal had liabilities of € 11.1bn due within one year and liabilities of € 3.48bn beyond. In return, he had 6.41 billion euros in cash and 4.38 billion euros in receivables due within 12 months. Its liabilities are therefore 3.81 billion euros more than the combination of its cash and short-term receivables.
This state of affairs indicates that L’Oréal’s balance sheet appears to be quite strong, with its total liabilities roughly equal to its cash. So the € 204.5 billion company is highly unlikely to be cash-strapped, but still worth keeping an eye on the balance sheet. Despite its notable liabilities, L’Oréal enjoys a clean cash flow, so it’s fair to say that it doesn’t have a heavy debt load!
But the flip side is that L’Oréal saw its EBIT drop 6.1% last year. If profits continue to decline at this rate, the business may find it increasingly difficult to manage debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future profits, more than anything, that will determine L’Oréal’s ability to maintain a healthy balance sheet in the future. So, if you want to see what the professionals are thinking, you might find this free analyst earnings forecast report interesting.
Finally, a business can only pay off its debts with cash, not book profits. L’Oréal may have net cash on the balance sheet, but it’s always interesting to watch the extent to which the company converts its earnings before interest and taxes (EBIT) into free cash flow, as this will influence both its need and its ability to manage debt. Over the past three years, L’Oréal has generated free cash flow of 92% of its very robust EBIT, more than expected. This puts him in a very strong position to pay off his debt.
We could understand if investors are worried about L’Oréal’s liabilities, but we can be reassured by the fact that it has a net cash position of 5.55 billion euros. And it impressed us with free cash flow of 5.5 billion euros, or 92% of its EBIT. So is L’Oréal’s debt a risk? It does not seem to us. Above most other metrics, we believe it’s important to track how quickly earnings per share are growing, if at all. If you have also noticed this, you are in luck because today you can view this interactive graph of historical earnings per share of L’Oréal for free.
If, after all of this, you’re more interested in a fast-growing company with a rock-solid balance sheet, then check out our list of cash-flow net-growth stocks right now.
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