David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, MGP Ingredients, Inc. (NASDAQ:MGPI) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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 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, 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 MGP Ingredients's Net Debt?
You can click the graphic below for the historical numbers, but it shows that MGP Ingredients had US$41.3m of debt in September 2019, down from US$45.1m, one year before. However, it also had US$4.40m in cash, and so its net debt is US$36.9m.
How Healthy Is MGP Ingredients's Balance Sheet?
We can see from the most recent balance sheet that MGP Ingredients had liabilities of US$35.1m falling due within a year, and liabilities of US$52.5m due beyond that. On the other hand, it had cash of US$4.40m and US$43.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$39.8m.
Since publicly traded MGP Ingredients shares are worth a total of US$778.8m, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).
MGP Ingredients's net debt is only 0.63 times its EBITDA. And its EBIT covers its interest expense a whopping 37.3 times over. So we're pretty relaxed about its super-conservative use of debt. Fortunately, MGP Ingredients grew its EBIT by 8.0% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if MGP Ingredients 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, MGP Ingredients's free cash flow amounted to 22% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Happily, MGP Ingredients's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that MGP Ingredients can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. We'd be motivated to research the stock further if we found out that MGP Ingredients insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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