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. 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. We can see that Nomad Foods Limited (NYSE:NOMD) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Nomad Foods's Debt?
As you can see below, at the end of June 2019, Nomad Foods had €1.91b of debt, up from €1.81b a year ago. Click the image for more detail. However, it does have €719.8m in cash offsetting this, leading to net debt of about €1.19b.
How Healthy Is Nomad Foods's Balance Sheet?
According to the last reported balance sheet, Nomad Foods had liabilities of €792.0m due within 12 months, and liabilities of €2.51b due beyond 12 months. Offsetting these obligations, it had cash of €719.8m as well as receivables valued at €190.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €2.39b.
This is a mountain of leverage relative to its market capitalization of €3.62b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Nomad Foods has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 5.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We saw Nomad Foods grow its EBIT by 9.3% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Nomad 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, 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, Nomad Foods produced sturdy free cash flow equating to 72% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
When it comes to the balance sheet, the standout positive for Nomad Foods was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. For example, its net debt to EBITDA makes us a little nervous about its debt. Looking at all this data makes us feel a little cautious about Nomad Foods's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you're interested in Nomad Foods, you may well want to click here to check an interactive graph of its earnings per share history.
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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