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Is Associated British Foods (LON:ABF) Using Too Much Debt?

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Simply Wall St
·4 min read
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The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that Associated British Foods plc (LON:ABF) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Associated British Foods

What Is Associated British Foods's Net Debt?

The image below, which you can click on for greater detail, shows that Associated British Foods had debt of UK£472.0m at the end of September 2020, a reduction from UK£574.0m over a year. But on the other hand it also has UK£2.03b in cash, leading to a UK£1.56b net cash position.

debt-equity-history-analysis
debt-equity-history-analysis

How Healthy Is Associated British Foods's Balance Sheet?

The latest balance sheet data shows that Associated British Foods had liabilities of UK£3.15b due within a year, and liabilities of UK£4.08b falling due after that. Offsetting this, it had UK£2.03b in cash and UK£1.23b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£3.98b.

This deficit isn't so bad because Associated British Foods is worth a massive UK£16.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt. While it does have liabilities worth noting, Associated British Foods also has more cash than debt, so we're pretty confident it can manage its debt safely.

In fact Associated British Foods's saving grace is its low debt levels, because its EBIT has tanked 32% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Associated British Foods's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. While Associated British Foods has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Associated British Foods recorded free cash flow worth 71% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While Associated British Foods does have more liabilities than liquid assets, it also has net cash of UK£1.56b. The cherry on top was that in converted 71% of that EBIT to free cash flow, bringing in UK£1.1b. So we don't have any problem with Associated British Foods's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 1 warning sign for Associated British Foods that you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

This article by Simply Wall St is general in nature. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com.