Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Hostess Brands, Inc. (NASDAQ:TWNK) makes use of debt. But is this debt a concern to shareholders?
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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
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What Is Hostess Brands's Debt?
As you can see below, Hostess Brands had US$1.08b of debt, at September 2022, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$232.7m in cash, and so its net debt is US$847.4m.
How Healthy Is Hostess Brands' Balance Sheet?
The latest balance sheet data shows that Hostess Brands had liabilities of US$244.6m due within a year, and liabilities of US$1.56b falling due after that. Offsetting this, it had US$232.7m in cash and US$199.9m in receivables that were due within 12 months. So it has liabilities totalling US$1.37b more than its cash and near-term receivables, combined.
This deficit isn't so bad because Hostess Brands is worth US$3.37b, and thus could probably raise enough capital to shore up 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.
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.
Hostess Brands has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 5.4 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Sadly, Hostess Brands's EBIT actually dropped 4.4% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hostess Brands 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Hostess Brands recorded free cash flow worth 63% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On our analysis Hostess Brands's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its net debt to EBITDA makes us a little nervous about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Hostess Brands's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example - Hostess Brands has 1 warning sign we think you should be aware of.
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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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.