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 can see that Nestlé S.A. (VTX:NESN) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Nestlé's Debt?
As you can see below, at the end of June 2021, Nestlé had CHF42.2b of debt, up from CHF38.4b a year ago. Click the image for more detail. However, it also had CHF6.44b in cash, and so its net debt is CHF35.7b.
A Look At Nestlé's Liabilities
According to the last reported balance sheet, Nestlé had liabilities of CHF38.6b due within 12 months, and liabilities of CHF42.0b due beyond 12 months. Offsetting these obligations, it had cash of CHF6.44b as well as receivables valued at CHF11.9b due within 12 months. So its liabilities total CHF62.2b more than the combination of its cash and short-term receivables.
Given Nestlé has a humongous market capitalization of CHF315.8b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Nestlé's net debt to EBITDA ratio of about 2.2 suggests only moderate use of debt. And its strong interest cover of 20.1 times, makes us even more comfortable. Unfortunately, Nestlé's EBIT flopped 11% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Nestlé 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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 72% 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.
Both Nestlé's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. 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 Nestlé 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. 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. We've identified 1 warning sign with Nestlé , and understanding them should be part of your investment process.
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.
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