Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 The Middleby Corporation (NASDAQ:MIDD) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.
What Is Middleby's Net Debt?
As you can see below, Middleby had US$2.02b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have US$81.7m in cash offsetting this, leading to net debt of about US$1.94b.
How Healthy Is Middleby's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Middleby had liabilities of US$565.3m due within 12 months and liabilities of US$2.52b due beyond that. Offsetting this, it had US$81.7m in cash and US$431.7m in receivables that were due within 12 months. So its liabilities total US$2.57b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Middleby is worth US$6.13b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Middleby's debt is 2.9 times its EBITDA, and its EBIT cover its interest expense 6.7 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. If Middleby can keep growing EBIT at last year's rate of 16% over the last year, then it will find its debt load easier to manage. 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 Middleby can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Middleby produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Both Middleby's ability to to grow its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. On the other hand, its net debt to EBITDA makes us a little less comfortable about its debt. Considering this range of data points, we think Middleby is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Over time, share prices tend to follow earnings per share, so if you're interested in Middleby, you may well want to click here to check an interactive graph of its earnings per share history.
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.
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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.