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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Farmer Bros. Co. (NASDAQ:FARM) 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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Farmer Bros's Debt?
The image below, which you can click on for greater detail, shows that at September 2021 Farmer Bros had debt of US$89.7m, up from US$73.7m in one year. However, it does have US$6.01m in cash offsetting this, leading to net debt of about US$83.7m.
How Strong Is Farmer Bros' Balance Sheet?
The latest balance sheet data shows that Farmer Bros had liabilities of US$81.8m due within a year, and liabilities of US$155.9m falling due after that. Offsetting these obligations, it had cash of US$6.01m as well as receivables valued at US$43.4m due within 12 months. So its liabilities total US$188.3m more than the combination of its cash and short-term receivables.
This deficit casts a shadow over the US$113.7m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Farmer Bros would probably need a major re-capitalization if its creditors were to demand repayment. 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 Farmer Bros'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.
Over 12 months, Farmer Bros made a loss at the EBIT level, and saw its revenue drop to US$409m, which is a fall of 11%. That's not what we would hope to see.
Not only did Farmer Bros's revenue slip over the last twelve months, but it also produced negative earnings before interest and tax (EBIT). Its EBIT loss was a whopping US$23m. Considering that alongside the liabilities mentioned above make us nervous about the company. It would need to improve its operations quickly for us to be interested in it. Not least because it burned through US$30m in negative free cash flow over the last year. That means it's on the risky side of things. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for Farmer Bros (1 is concerning!) that you should be aware of before investing here.
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.
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.