Premium Brands Holdings (TSE:PBH) Takes On Some Risk With Its Use Of Debt

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.' 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 can see that Premium Brands Holdings Corporation (TSE:PBH) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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.

Check out our latest analysis for Premium Brands Holdings

What Is Premium Brands Holdings's Debt?

As you can see below, at the end of September 2022, Premium Brands Holdings had CA$1.96b of debt, up from CA$1.27b a year ago. Click the image for more detail. Net debt is about the same, since the it doesn't have much cash.

A Look At Premium Brands Holdings' Liabilities

We can see from the most recent balance sheet that Premium Brands Holdings had liabilities of CA$577.0m falling due within a year, and liabilities of CA$2.65b due beyond that. On the other hand, it had cash of CA$38.3m and CA$632.6m worth of receivables due within a year. So its liabilities total CA$2.56b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Premium Brands Holdings has a market capitalization of CA$4.37b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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.

Strangely Premium Brands Holdings has a sky high EBITDA ratio of 5.3, implying high debt, but a strong interest coverage of 13.4. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. One way Premium Brands Holdings could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 13%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Premium Brands Holdings 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.

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 that EBIT is backed by free cash flow. Over the last three years, Premium Brands Holdings saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Premium Brands Holdings's conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that Premium Brands Holdings is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Premium Brands Holdings you should be aware of, and 1 of them is a bit concerning.

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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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.