Warren Buffett famously said, '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. We note that Sanford Limited (NZSE:SAN) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Sanford Carry?
The image below, which you can click on for greater detail, shows that at March 2021 Sanford had debt of NZ$200.0m, up from NZ$165.9m in one year. However, it does have NZ$19.0m in cash offsetting this, leading to net debt of about NZ$181.0m.
How Healthy Is Sanford's Balance Sheet?
We can see from the most recent balance sheet that Sanford had liabilities of NZ$116.5m falling due within a year, and liabilities of NZ$214.0m due beyond that. Offsetting this, it had NZ$19.0m in cash and NZ$84.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$227.3m.
Sanford has a market capitalization of NZ$458.2m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Sanford's debt is 3.8 times its EBITDA, and its EBIT cover its interest expense 2.5 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Worse, Sanford's EBIT was down 54% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Sanford can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Sanford's free cash flow amounted to 24% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Mulling over Sanford's attempt at (not) growing its EBIT, we're certainly not enthusiastic. Having said that, its ability to handle its total liabilities isn't such a worry. We're quite clear that we consider Sanford to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Sanford you should know about.
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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