Here's Why Koninklijke Ahold Delhaize (AMS:AD) Can Manage Its Debt Responsibly

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 Koninklijke Ahold Delhaize N.V. (AMS:AD) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Koninklijke Ahold Delhaize

What Is Koninklijke Ahold Delhaize's Debt?

As you can see below, Koninklijke Ahold Delhaize had €4.97b of debt at January 2021, down from €5.75b a year prior. However, it does have €3.11b in cash offsetting this, leading to net debt of about €1.86b.

How Healthy Is Koninklijke Ahold Delhaize's Balance Sheet?

We can see from the most recent balance sheet that Koninklijke Ahold Delhaize had liabilities of €12.8b falling due within a year, and liabilities of €15.4b due beyond that. On the other hand, it had cash of €3.11b and €2.13b worth of receivables due within a year. So its liabilities total €23.0b more than the combination of its cash and short-term receivables.

This is a mountain of leverage even relative to its gargantuan market capitalization of €24.0b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

Koninklijke Ahold Delhaize has net debt of just 0.36 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 7.9 times, which is more than adequate. Also positive, Koninklijke Ahold Delhaize grew its EBIT by 28% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Koninklijke Ahold Delhaize's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Koninklijke Ahold Delhaize actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Happily, Koninklijke Ahold Delhaize's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But we must concede we find its level of total liabilities has the opposite effect. When we consider the range of factors above, it looks like Koninklijke Ahold Delhaize is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. Be aware that Koninklijke Ahold Delhaize is showing 3 warning signs in our investment analysis , 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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