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. As with many other companies The Middleby Corporation (NASDAQ:MIDD) makes use of debt. But should shareholders be worried about its use of debt?
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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Middleby's Debt?
You can click the graphic below for the historical numbers, but it shows that Middleby had US$1.78b of debt in April 2021, down from US$2.26b, one year before. However, because it has a cash reserve of US$309.3m, its net debt is less, at about US$1.47b.
How Strong Is Middleby's Balance Sheet?
According to the last reported balance sheet, Middleby had liabilities of US$714.4m due within 12 months, and liabilities of US$2.58b due beyond 12 months. On the other hand, it had cash of US$309.3m and US$446.8m worth of receivables due within a year. So it has liabilities totalling US$2.54b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Middleby has a huge market capitalization of US$10.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Middleby's debt is 2.9 times its EBITDA, and its EBIT cover its interest expense 5.1 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Shareholders should be aware that Middleby's EBIT was down 26% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Middleby'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 we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Middleby recorded free cash flow worth 79% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Based on what we've seen Middleby is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. Looking at all this data makes us feel a little cautious about Middleby's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. Be aware that Middleby is showing 1 warning sign in our investment analysis , you should know about...
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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The Middleby Corporation designs, manufactures, markets, distributes, and services a range of foodservice, food processing, and residential kitchen equipment in the United States, Canada, Asia, Europe, the Middle East, and Latin America.
Fair value with questionable track record.