It's common wisdom that the lower a company's debt levels are, the lower the level of risk in the investment. This can be true if you're looking at two comparable companies and one has an extraordinary amount of debt, while the other does not. This is particularly true when looking at retailers.
Many retailers carry little or no debt, but that doesn't necessarily mean that these companies are lower-risk investments. Abercrombie & Fitch (NYSE:ANF), Buckle (NYSE:BKE), and Urban Outfitters (NASDAQ:URBN) carry no debt. But as we're seeing with Pier 1 Imports (NYSE:PIR), retailers do carry a significant amount of inventory risk. If the purchasing, fashion, or marketing is off, selling those wares at the high prices that generate juicy margins just isn't possible, and earnings growth quickly turns into earnings declines or losses.
Another liability that retailers have, but don't carry on the balance sheet, is operating leases. Many of my colleagues at Fool HQ treat these leases as debt, because they're contractual agreements that must be paid -- although it's important to note that they're not interest-bearing. Because I've seen REITs looking to replace weak tenants with strong ones and, in the process, willing to accept termination fees that are less than the remaining value of the lease, I don't treat the entire balance as debt. The different processes for analyzing lease liabilities aren't nearly as important as recognizing the fact that there are often large off-balance sheet liabilities that will only be found in a retailer's footnotes.
On the other side of the coin, there are companies such as Staples (NASDAQ:SPLS), Kohl's (NYSE:KSS), and Motley Fool Inside Value selection Home Depot (NYSE:HD). All are retailers, and all carry a fair amount of long-term debt on the balance sheet. These three companies aren't necessarily riskier than those mentioned earlier. In fact, I'd argue that in the case of these three companies, the debt is a testament to the fact that they carry much less merchandising risk than the average apparel retailer.
That really is the crux of the matter. Little or no debt can, but doesn't always, mean less risk. Before picking up shares in any retailer, it pays to look beyond the debt and understand the nature of the business, because a little bit of debt can actually be a very good thing for a company with a predictable business model.
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Nathan Parmelee had no financial interest in any of the companies mentioned. The Motley Fool has an ironclad disclosure policy .
