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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.’ 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, Premier Foods plc (LON:PFD) does carry debt. But the more important question is: how much risk is that debt creating?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Premier Foods’s Net Debt?
As you can see below, Premier Foods had UK£497.7m of debt at March 2019, down from UK£520.0m a year prior. On the flip side, it has UK£27.8m in cash leading to net debt of about UK£469.9m.
A Look At Premier Foods’s Liabilities
The latest balance sheet data shows that Premier Foods had liabilities of UK£249.3m due within a year, and liabilities of UK£1.02b falling due after that. Offsetting this, it had UK£27.8m in cash and UK£77.4m in receivables that were due within 12 months. So its liabilities total UK£1.16b more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the UK£317.9m company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt After all, Premier Foods would likely require a major re-capitalisation if it had to pay its creditors today. Since Premier Foods does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Premier Foods shareholders face the double whammy of a high net debt to EBITDA ratio (10.6), and fairly weak interest coverage, since EBIT is just 0.10 times the interest expense. This means we’d consider it to have a heavy debt load. Even worse, Premier Foods saw its EBIT tank 94% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Premier Foods’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.
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, Premier Foods produced sturdy free cash flow equating to 66% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
To be frank both Premier Foods’s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. After considering the datapoints discussed, we think Premier Foods has too much debt. While some investors love that sort of risky play, it’s certainly not our cup of tea. While Premier Foods didn’t make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.