Premier Foods (LON:PFD) Has A Pretty Healthy Balance Sheet

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Premier Foods plc (LON:PFD) makes use of debt. But the more important question is: how much risk is that debt creating?

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 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.

See our latest analysis for Premier Foods

What Is Premier Foods's Debt?

You can click the graphic below for the historical numbers, but it shows that Premier Foods had UK£423.2m of debt in September 2020, down from UK£499.4m, one year before. However, because it has a cash reserve of UK£40.4m, its net debt is less, at about UK£382.8m.

How Healthy Is Premier Foods' Balance Sheet?

The latest balance sheet data shows that Premier Foods had liabilities of UK£290.6m due within a year, and liabilities of UK£923.4m falling due after that. Offsetting this, it had UK£40.4m in cash and UK£107.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£1.07b.

Given this deficit is actually higher than the company's market capitalization of UK£826.7m, we think shareholders really should watch Premier Foods's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Premier Foods has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 2.7 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The silver lining is that Premier Foods grew its EBIT by 803% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Premier Foods generated free cash flow amounting to a very robust 90% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Both Premier Foods's ability to to convert EBIT to free cash flow and its EBIT growth rate gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. Looking at all this data makes us feel a little cautious about Premier Foods's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Like risks, for instance. Every company has them, and we've spotted 2 warning signs for Premier Foods (of which 1 makes us a bit uncomfortable!) you should know about.

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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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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