These 4 Measures Indicate That Koninklijke Ahold Delhaize (AMS:AD) Is Using Debt Reasonably Well

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that Koninklijke Ahold Delhaize N.V. (AMS:AD) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 examine debt levels, we first consider both cash and debt levels, together.

Our analysis indicates that AD is potentially undervalued!

What Is Koninklijke Ahold Delhaize's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of July 2022 Koninklijke Ahold Delhaize had €6.71b of debt, an increase on €6.36b, over one year. However, it does have €3.46b in cash offsetting this, leading to net debt of about €3.26b.

How Healthy Is Koninklijke Ahold Delhaize's Balance Sheet?

According to the last reported balance sheet, Koninklijke Ahold Delhaize had liabilities of €15.6b due within 12 months, and liabilities of €18.5b due beyond 12 months. Offsetting this, it had €3.46b in cash and €2.37b in receivables that were due within 12 months. So it has liabilities totalling €28.3b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's huge €27.7b market capitalization, you might well be inclined to review the balance sheet intently. 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.

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).

While Koninklijke Ahold Delhaize's low debt to EBITDA ratio of 0.62 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.8 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. The good news is that Koninklijke Ahold Delhaize has increased its EBIT by 4.2% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Koninklijke Ahold Delhaize generated free cash flow amounting to a very robust 99% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

When it comes to the balance sheet, the standout positive for Koninklijke Ahold Delhaize was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren't so heartening. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Koninklijke Ahold Delhaize is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 1 warning sign with Koninklijke Ahold Delhaize , and understanding them should be part of your investment process.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.