Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Hormel Foods Corporation (NYSE:HRL) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Hormel Foods's Debt?
The chart below, which you can click on for greater detail, shows that Hormel Foods had US$250.0m in debt in April 2020; about the same as the year before. But it also has US$622.9m in cash to offset that, meaning it has US$372.9m net cash.
A Look At Hormel Foods's Liabilities
According to the last reported balance sheet, Hormel Foods had liabilities of US$1.32b due within 12 months, and liabilities of US$904.4m due beyond 12 months. Offsetting this, it had US$622.9m in cash and US$536.4m in receivables that were due within 12 months. So its liabilities total US$1.1b more than the combination of its cash and short-term receivables.
Since publicly traded Hormel Foods shares are worth a very impressive total of US$28.3b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Hormel Foods also has more cash than debt, so we're pretty confident it can manage its debt safely.
But the other side of the story is that Hormel Foods saw its EBIT decline by 5.3% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 Hormel Foods 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, a company can only pay off debt with cold hard cash, not accounting profits. Hormel Foods may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Hormel Foods recorded free cash flow worth 73% 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.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Hormel Foods has US$372.9m in net cash. And it impressed us with free cash flow of US$761m, being 73% of its EBIT. So is Hormel Foods's debt a risk? It doesn't seem so to us. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Hormel Foods that you should be aware of before investing here.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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.
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