Finsbury Food Group (LON:FIF) Has A Somewhat Strained Balance Sheet

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Finsbury Food Group Plc (LON:FIF) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Finsbury Food Group

What Is Finsbury Food Group's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Finsbury Food Group had UK£30.8m of debt in December 2020, down from UK£43.9m, one year before. On the flip side, it has UK£9.56m in cash leading to net debt of about UK£21.3m.

How Healthy Is Finsbury Food Group's Balance Sheet?

The latest balance sheet data shows that Finsbury Food Group had liabilities of UK£66.9m due within a year, and liabilities of UK£59.0m falling due after that. On the other hand, it had cash of UK£9.56m and UK£50.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£65.9m.

This is a mountain of leverage relative to its market capitalization of UK£96.5m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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

With net debt sitting at just 0.99 times EBITDA, Finsbury Food Group is arguably pretty conservatively geared. And it boasts interest cover of 9.7 times, which is more than adequate. The modesty of its debt load may become crucial for Finsbury Food Group if management cannot prevent a repeat of the 26% cut to EBIT over the last year. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. 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 Finsbury Food Group 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 we always check how much of that EBIT is translated into free cash flow. During the last three years, Finsbury Food Group produced sturdy free cash flow equating to 52% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Finsbury Food Group's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its interest cover was re-invigorating. Taking the abovementioned factors together we do think Finsbury Food Group's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Given our hesitation about the stock, it would be good to know if Finsbury Food Group insiders have sold any shares recently. You click here to find out if insiders have sold recently.

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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