WPP (LON:WPP) has a fairly healthy balance sheet
Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to 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. We note that WPP plc (LON:WPP) has debt on its balance sheet. But should shareholders worry about its use of debt?
Why is debt risky?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
See our latest analysis for WPP
What is WPP’s debt?
The image below, which you can click on for more details, shows WPP had £4.78billion in debt at the end of December 2021, a reduction from £13.6billion year on year . However, he also had £3.88 billion in cash, so his net debt is £901.1 million.
How healthy is WPP’s balance sheet?
We can see from the most recent balance sheet that WPP had liabilities of £16.5bn due within a year, and liabilities of £7.32bn due beyond. As compensation for these obligations, it had cash of £3.88 billion as well as receivables valued at £11.2 billion and due within 12 months. Thus, its liabilities total £8.68 billion more than the combination of its cash and short-term receivables.
This deficit is considerable compared to its very large market capitalization of £12.3 billion, so it suggests that shareholders should monitor WPP’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Looking at its net debt to EBITDA ratio of 0.62 and its interest coverage of 5.8 times, it seems to us that WPP is probably using debt quite sensibly. But the interest payments are certainly enough to make us think about the affordability of its debt. Although WPP posted an EBIT loss last year, it was also good to see that it generated £1.2bn of EBIT in the last twelve months. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine WPP’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
But our last consideration is also important, because a company cannot pay off its debts with paper profits; he needs cash. It is therefore worth checking how much of earnings before interest and tax (EBIT) is supported by free cash flow. Over the past year, WPP has actually produced more free cash flow than EBIT. There’s nothing better than incoming money to stay in the good books of your lenders.
Our point of view
On the balance sheet, the most notable positive for WPP is the fact that it appears to be able to convert EBIT to free cash flow with confidence. But the other factors we noted above weren’t so encouraging. For example, his level of total liabilities makes us a little nervous about his debt. Given this range of data points, we believe WPP 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. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks reside on the balance sheet, far from it. For example, we have identified 1 warning sign for WPP which you should be aware of.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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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.