Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies Flowers Foods, Inc. (NYSE:FLO) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Flowers Foods Carry?
You can click the graphic below for the historical numbers, but it shows that as of July 2019 Flowers Foods had US$902.9m of debt, an increase on US$834.9m, over one year. Net debt is about the same, since the it doesn’t have much cash.
How Strong Is Flowers Foods’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Flowers Foods had liabilities of US$494.9m due within 12 months and liabilities of US$1.43b due beyond that. On the other hand, it had cash of US$9.77m and US$313.4m worth of receivables due within a year. So it has liabilities totalling US$1.60b more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Flowers Foods is worth US$4.73b, 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.
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).
Flowers Foods’s net debt to EBITDA ratio of about 2.2 suggests only moderate use of debt. And its commanding EBIT of 27.7 times its interest expense, implies the debt load is as light as a peacock feather. Unfortunately, Flowers Foods saw its EBIT slide 7.9% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Flowers 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, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Flowers Foods recorded free cash flow worth 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Flowers Foods’s interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. On the other hand, its EBIT growth rate makes us a little less comfortable about its debt. Considering this range of data points, we think Flowers Foods 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. Given Flowers Foods has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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