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. 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 MGP Ingredients, Inc. (NASDAQ:MGPI) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does MGP Ingredients Carry?
As you can see below, MGP Ingredients had US$41.3m of debt at September 2019, down from US$45.1m a year prior. However, it does have US$4.40m in cash offsetting this, leading to net debt of about US$36.9m.
A Look At MGP Ingredients’s Liabilities
According to the last reported balance sheet, MGP Ingredients had liabilities of US$35.1m due within 12 months, and liabilities of US$52.5m due beyond 12 months. Offsetting these obligations, it had cash of US$4.40m as well as receivables valued at US$43.4m due within 12 months. So its liabilities total US$39.8m more than the combination of its cash and short-term receivables.
Given MGP Ingredients has a market capitalization of US$585.4m, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
MGP Ingredients has a low net debt to EBITDA ratio of only 0.63. And its EBIT easily covers its interest expense, being 37.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, MGP Ingredients grew its EBIT by 8.0% in the last year, making that debt load look even more manageable. 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 MGP Ingredients 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, MGP Ingredients’s free cash flow amounted to 22% of its EBIT, less than we’d expect. That’s not great, when it comes to paying down debt.
The good news is that MGP Ingredients’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its conversion of EBIT to free cash flow. All these things considered, it appears that MGP Ingredients can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. 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. To that end, you should be aware of the 1 warning sign we’ve spotted with MGP Ingredients .
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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