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.' 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 Sanford Limited (NZSE:SAN) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Sanford Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Sanford had NZ$187.2m of debt, an increase on NZ$139.0m, over one year. And it doesn't have much cash, so its net debt is about the same.
A Look At Sanford's Liabilities
We can see from the most recent balance sheet that Sanford had liabilities of NZ$120.8m falling due within a year, and liabilities of NZ$199.5m due beyond that. Offsetting this, it had NZ$2.96m in cash and NZ$67.3m in receivables that were due within 12 months. So it has liabilities totalling NZ$250.0m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Sanford is worth NZ$421.7m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Sanford's debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 3.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even worse, Sanford saw its EBIT tank 44% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sanford can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Sanford recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
We'd go so far as to say Sanford's EBIT growth rate was disappointing. But at least its conversion of EBIT to free cash flow is not so bad. Overall, we think it's fair to say that Sanford has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Sanford that you should be aware of before investing here.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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