These 4 Measures Indicate That McPherson's (ASX:MCP) Is Using Debt Reasonably Well

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that McPherson's Limited (ASX:MCP) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

View our latest analysis for McPherson's

What Is McPherson's's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 McPherson's had AU$24.9m of debt, an increase on AU$18.8m, over one year. However, it does have AU$11.0m in cash offsetting this, leading to net debt of about AU$13.9m.

A Look At McPherson's' Liabilities

Zooming in on the latest balance sheet data, we can see that McPherson's had liabilities of AU$78.5m due within 12 months and liabilities of AU$21.0m due beyond that. Offsetting these obligations, it had cash of AU$11.0m as well as receivables valued at AU$37.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$51.4m.

This is a mountain of leverage relative to its market capitalization of AU$74.1m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

McPherson's has net debt of just 1.1 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.0 times the interest expense over the last year. It was also good to see that despite losing money on the EBIT line last year, McPherson's turned things around in the last 12 months, delivering and EBIT of AU$10.0m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if McPherson's 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the most recent year, McPherson's recorded free cash flow worth 56% 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.

Our View

McPherson's's net debt to EBITDA was a real positive on this analysis, as was its interest cover. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about McPherson's's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that McPherson's is showing 4 warning signs in our investment analysis , and 1 of those is a bit unpleasant...

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.