Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Wesfarmers Limited (ASX:WES) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company 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 and debt together.

View our latest analysis for Wesfarmers

What Is Wesfarmers's Net Debt?

As you can see below, Wesfarmers had AU$3.03b of debt at June 2019, down from AU$4.12b a year prior. However, it also had AU$795.0m in cash, and so its net debt is AU$2.23b.

A Look At Wesfarmers's Liabilities

Zooming in on the latest balance sheet data, we can see that Wesfarmers had liabilities of AU$5.22b due within 12 months and liabilities of AU$3.15b due beyond that. Offsetting these obligations, it had cash of AU$795.0m as well as receivables valued at AU$1.03b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$6.54b.

Of course, Wesfarmers has a titanic market capitalization of AU$43.8b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.