These 4 Measures Indicate That Sodexo (EPA:SW) Is Using Debt Reasonably Well

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Sodexo S.A. (EPA:SW) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Sodexo

What Is Sodexo's Debt?

You can click the graphic below for the historical numbers, but it shows that as of August 2021 Sodexo had €6.10b of debt, an increase on €5.02b, over one year. On the flip side, it has €3.54b in cash leading to net debt of about €2.56b.

How Strong Is Sodexo's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Sodexo had liabilities of €8.85b due within 12 months and liabilities of €6.96b due beyond that. Offsetting these obligations, it had cash of €3.54b as well as receivables valued at €4.27b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €8.00b.

This is a mountain of leverage even relative to its gargantuan market capitalization of €12.2b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Sodexo's debt is 3.0 times its EBITDA, and its EBIT cover its interest expense 5.4 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Sodexo grew its EBIT by 2.9% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Sodexo'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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Sodexo produced sturdy free cash flow equating to 79% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

When it comes to the balance sheet, the standout positive for Sodexo was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Sodexo'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. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with Sodexo (including 1 which is concerning) .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.