Is Diageo (LON:DGE) A Risky Investment?

By
Simply Wall St
Published
May 18, 2022
LSE:DGE
Source: Shutterstock

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Diageo plc (LON:DGE) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Diageo

What Is Diageo's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Diageo had UK£13.9b of debt in December 2021, down from UK£15.3b, one year before. On the flip side, it has UK£1.78b in cash leading to net debt of about UK£12.1b.

debt-equity-history-analysis
LSE:DGE Debt to Equity History May 18th 2022

How Strong Is Diageo's Balance Sheet?

According to the last reported balance sheet, Diageo had liabilities of UK£7.60b due within 12 months, and liabilities of UK£16.2b due beyond 12 months. Offsetting these obligations, it had cash of UK£1.78b as well as receivables valued at UK£3.48b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£18.6b.

Diageo has a very large market capitalization of UK£87.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Diageo has a debt to EBITDA ratio of 2.7, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 13.0 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Importantly, Diageo grew its EBIT by 31% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Diageo'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Diageo recorded free cash flow worth 64% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Diageo's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its net debt to EBITDA. Looking at the bigger picture, we think Diageo's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Diageo that you should be aware of before investing here.

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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