Stock Analysis

We Think Associated British Foods (LON:ABF) Is Taking Some Risk With Its Debt

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LSE:ABF
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Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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, Associated British Foods plc (LON:ABF) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we think about a company's use of debt, we first look at cash and debt together.

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What Is Associated British Foods's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Associated British Foods had UK£440.0m of debt in February 2021, down from UK£548.0m, one year before. However, its balance sheet shows it holds UK£1.15b in cash, so it actually has UK£705.0m net cash.

debt-equity-history-analysis
LSE:ABF Debt to Equity History August 13th 2021

How Strong Is Associated British Foods' Balance Sheet?

According to the last reported balance sheet, Associated British Foods had liabilities of UK£2.69b due within 12 months, and liabilities of UK£3.85b due beyond 12 months. On the other hand, it had cash of UK£1.15b and UK£1.39b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£4.00b.

While this might seem like a lot, it is not so bad since Associated British Foods has a huge market capitalization of UK£16.4b, 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. Despite its noteworthy liabilities, Associated British Foods boasts net cash, so it's fair to say it does not have a heavy debt load!

Importantly, Associated British Foods's EBIT fell a jaw-dropping 57% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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, a company can only pay off debt with cold hard cash, not accounting profits. 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 57% 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.

Summing up

While Associated British Foods does have more liabilities than liquid assets, it also has net cash of UK£705.0m. So although we see some areas for improvement, we're not too worried about Associated British Foods's balance sheet. 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. We've identified 1 warning sign with Associated British Foods , and understanding them should be part of your investment process.

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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