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. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Conagra Brands, Inc. (NYSE:CAG) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Conagra Brands's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of August 2019 Conagra Brands had US$10.4b of debt, an increase on US$3.85b, over one year. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Conagra Brands's Balance Sheet?
According to the last reported balance sheet, Conagra Brands had liabilities of US$2.45b due within 12 months, and liabilities of US$12.4b due beyond 12 months. Offsetting these obligations, it had cash of US$64.7m as well as receivables valued at US$776.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$14.0b.
Given this deficit is actually higher than the company's massive market capitalization of US$13.2b, we think shareholders really should watch Conagra Brands's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With a net debt to EBITDA ratio of 5.1, it's fair to say Conagra Brands does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.8 times, suggesting it can responsibly service its obligations. Looking on the bright side, Conagra Brands boosted its EBIT by a silky 40% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Conagra Brands can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Conagra Brands recorded free cash flow worth 55% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Neither Conagra Brands's ability handle its debt, based on its EBITDA, nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. We think that Conagra Brands's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.