The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a 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, Hormel Foods Corporation (NYSE:HRL) does carry debt. But is this debt a concern to shareholders?
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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Hormel Foods’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Hormel Foods had US$250.0m of debt in July 2019, down from US$719.8m, one year before. But on the other hand it also has US$574.3m in cash, leading to a US$324.3m net cash position.
How Healthy Is Hormel Foods’s Balance Sheet?
According to the last reported balance sheet, Hormel Foods had liabilities of US$1.07b due within 12 months, and liabilities of US$990.2m due beyond 12 months. On the other hand, it had cash of US$574.3m and US$529.3m worth of receivables due within a year. So it has liabilities totalling US$959.7m more than its cash and near-term receivables, combined.
Given Hormel Foods has a humongous market capitalization of US$22.8b, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Hormel Foods boasts net cash, so it’s fair to say it does not have a heavy debt load!
Fortunately, Hormel Foods grew its EBIT by 4.4% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hormel Foods 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. Hormel Foods 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. During the last three years, Hormel Foods produced sturdy free cash flow equating to 66% 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.
We could understand if investors are concerned about Hormel Foods’s liabilities, but we can be reassured by the fact it has has net cash of US$324.3m. So we don’t think Hormel Foods’s use of debt is risky. We’d be motivated to research the stock further if we found out that Hormel Foods 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 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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