Here's Why Nestlé (VTX:NESN) Can Manage Its Debt Responsibly

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.' 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. As with many other companies Nestlé S.A. (VTX:NESN) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Nestlé

What Is Nestlé's Debt?

As you can see below, at the end of December 2020, Nestlé had CHF37.3b of debt, up from CHF34.1b a year ago. Click the image for more detail. However, it does have CHF8.71b in cash offsetting this, leading to net debt of about CHF28.6b.

A Look At Nestlé's Liabilities

The latest balance sheet data shows that Nestlé had liabilities of CHF39.7b due within a year, and liabilities of CHF37.8b falling due after that. On the other hand, it had cash of CHF8.71b and CHF11.5b worth of receivables due within a year. So its liabilities total CHF57.4b more than the combination of its cash and short-term receivables.

Given Nestlé has a humongous market capitalization of CHF293.3b, 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.

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).

Nestlé's net debt to EBITDA ratio of about 1.7 suggests only moderate use of debt. And its commanding EBIT of 19.3 times its interest expense, implies the debt load is as light as a peacock feather. On the other hand, Nestlé saw its EBIT drop by 8.5% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Nestlé 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. During the last three years, Nestlé produced sturdy free cash flow equating to 71% 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.

Our View

The good news is that Nestlé's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its EBIT growth rate does undermine this impression a bit. Looking at all the aforementioned factors together, it strikes us that Nestlé can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Nestlé you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

When trading Nestlé or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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. 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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.