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. We note that Sanderson Farms, Inc. (NASDAQ:SAFM) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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 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, 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 Sanderson Farms's Debt?
You can click the graphic below for the historical numbers, but it shows that as of July 2019 Sanderson Farms had US$30.0m of debt, an increase on none, over one year. But it also has US$74.3m in cash to offset that, meaning it has US$44.3m net cash.
A Look At Sanderson Farms's Liabilities
The latest balance sheet data shows that Sanderson Farms had liabilities of US$199.0m due within a year, and liabilities of US$124.5m falling due after that. Offsetting this, it had US$74.3m in cash and US$145.1m in receivables that were due within 12 months. So it has liabilities totalling US$104.2m more than its cash and near-term receivables, combined.
Since publicly traded Sanderson Farms shares are worth a total of US$3.64b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Sanderson Farms also has more cash than debt, so we're pretty confident it can manage its debt safely.
The modesty of its debt load may become crucial for Sanderson Farms if management cannot prevent a repeat of the 78% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sanderson Farms 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. Sanderson Farms 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. In the last three years, Sanderson Farms created free cash flow amounting to 4.9% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
We could understand if investors are concerned about Sanderson Farms's liabilities, but we can be reassured by the fact it has has net cash of US$44.3m. So while Sanderson Farms does not have a great balance sheet, it's certainly not too bad. Given our hesitation about the stock, it would be good to know if Sanderson Farms insiders have sold any shares recently. You click here to find out if insiders have sold recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.
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