Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk. 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, Sonoco Products Company (NYSE:SON) does carry debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Sonoco Products Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Sonoco Products had US$1.53b of debt, an increase on US$1.45b, over one year. On the flip side, it has US$96.3m in cash leading to net debt of about US$1.43b.
How Strong Is Sonoco Products's Balance Sheet?
We can see from the most recent balance sheet that Sonoco Products had liabilities of US$1.27b falling due within a year, and liabilities of US$1.82b due beyond that. Offsetting this, it had US$96.3m in cash and US$885.3m in receivables that were due within 12 months. So it has liabilities totalling US$2.11b more than its cash and near-term receivables, combined.
Sonoco Products has a market capitalization of US$5.79b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
With a debt to EBITDA ratio of 1.9, Sonoco Products uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.3 times interest expense) certainly does not do anything to dispel this impression. We saw Sonoco Products grow its EBIT by 9.2% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Sonoco Products'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Sonoco Products's free cash flow amounted to 46% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Sonoco Products's interest cover was a real positive on this analysis, as was its EBIT growth rate. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about Sonoco Products's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Sonoco Products insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
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