Is Farmer Bros (NASDAQ:FARM) Using Debt Sensibly?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Farmer Bros. Co. (NASDAQ:FARM) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Farmer Bros

What Is Farmer Bros's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2023 Farmer Bros had US$111.5m of debt, an increase on US$99.7m, over one year. However, it also had US$8.19m in cash, and so its net debt is US$103.4m.

A Look At Farmer Bros' Liabilities

The latest balance sheet data shows that Farmer Bros had liabilities of US$90.7m due within a year, and liabilities of US$160.5m falling due after that. Offsetting this, it had US$8.19m in cash and US$54.1m in receivables that were due within 12 months. So it has liabilities totalling US$188.9m more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the US$56.9m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. 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.

In the last year Farmer Bros wasn't profitable at an EBIT level, but managed to grow its revenue by 12%, to US$501m. We usually like to see faster growth from unprofitable companies, but each to their own.

Caveat Emptor

Importantly, Farmer Bros had an earnings before interest and tax (EBIT) loss over the last year. Its EBIT loss was a whopping US$35m. If you consider the significant liabilities mentioned above, we are extremely wary of this investment. Of course, it may be able to improve its situation with a bit of luck and good execution. Nevertheless, we would not bet on it given that it vaporized US$25m in cash over the last twelve months, and it doesn't have much by way of liquid assets. So we consider this a high risk stock and we wouldn't be at all surprised if the company asks shareholders for money before long. 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. Case in point: We've spotted 5 warning signs for Farmer Bros you should be aware of, and 2 of them are potentially serious.

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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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.