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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Coca-Cola Amatil Limited (ASX:CCL) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Coca-Cola Amatil
What Is Coca-Cola Amatil's Net Debt?
As you can see below, Coca-Cola Amatil had AU$2.47b of debt, at December 2018, which is about the same the year before. You can click the chart for greater detail. On the flip side, it has AU$1.05b in cash leading to net debt of about AU$1.42b.
How Strong Is Coca-Cola Amatil's Balance Sheet?
According to the last reported balance sheet, Coca-Cola Amatil had liabilities of AU$1.64b due within 12 months, and liabilities of AU$2.63b due beyond 12 months. Offsetting these obligations, it had cash of AU$1.05b as well as receivables valued at AU$995.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$2.22b.
This deficit isn't so bad because Coca-Cola Amatil is worth AU$7.65b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
Coca-Cola Amatil's net debt to EBITDA ratio of about 1.6 suggests only moderate use of debt. And its strong interest cover of 12.0 times, makes us even more comfortable. The bad news is that Coca-Cola Amatil saw its EBIT decline by 14% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Coca-Cola Amatil's ability to maintain a healthy balance sheet going forward. 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 it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Coca-Cola Amatil recorded free cash flow of 48% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Our View
Neither Coca-Cola Amatil's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. We think that Coca-Cola Amatil's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Given Coca-Cola Amatil 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.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Thank you for reading.