Stock Analysis

Does Associated British Foods (LON:ABF) Have A Healthy Balance Sheet?

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LSE:ABF
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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 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. As with many other companies Associated British Foods plc (LON:ABF) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Associated British Foods

How Much Debt Does Associated British Foods Carry?

As you can see below, Associated British Foods had UK£472.0m of debt at September 2020, down from UK£574.0m a year prior. However, it does have UK£2.03b in cash offsetting this, leading to net cash of UK£1.56b.

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LSE:ABF Debt to Equity History December 30th 2020

How Healthy Is Associated British Foods's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Associated British Foods had liabilities of UK£3.15b due within 12 months and liabilities of UK£4.08b due beyond that. On the other hand, it had cash of UK£2.03b and UK£1.23b worth of receivables due within a year. So its liabilities total UK£3.98b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Associated British Foods has a huge market capitalization of UK£18.2b, 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. While it does have liabilities worth noting, Associated British Foods also has more cash than debt, so we're pretty confident it can manage its debt safely.

The modesty of its debt load may become crucial for Associated British Foods if management cannot prevent a repeat of the 32% 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. 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 Associated British Foods 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Associated British Foods may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Associated British Foods produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While Associated British Foods does have more liabilities than liquid assets, it also has net cash of UK£1.56b. The cherry on top was that in converted 71% of that EBIT to free cash flow, bringing in UK£1.1b. So we don't have any problem with Associated British Foods's use of debt. 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. Take risks, for example - Associated British Foods has 3 warning signs we think you should be aware of.

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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