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Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. We note that Fresh Del Monte Produce Inc. (NYSE:FDP) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Fresh Del Monte Produce’s Debt?
As you can see below, Fresh Del Monte Produce had US$717.3m of debt at March 2019, down from US$794.7m a year prior. However, it does have US$21.9m in cash offsetting this, leading to net debt of about US$695.4m.
How Healthy Is Fresh Del Monte Produce’s Balance Sheet?
According to the last reported balance sheet, Fresh Del Monte Produce had liabilities of US$620.7m due within 12 months, and liabilities of US$1.09b due beyond 12 months. On the other hand, it had cash of US$21.9m and US$477.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.21b.
Given this deficit is actually higher than the company’s market capitalization of US$1.19b, we think shareholders really should watch Fresh Del Monte Produce’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Since Fresh Del Monte Produce does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Fresh Del Monte Produce has a debt to EBITDA ratio of 4.12 and its EBIT covered its interest expense 2.50 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. Worse, Fresh Del Monte Produce’s EBIT was down 61% over the last year. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Fresh Del Monte Produce can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Fresh Del Monte Produce recorded free cash flow worth 54% 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.
Mulling over Fresh Del Monte Produce’s attempt at (not) growing its EBIT, we’re certainly not enthusiastic. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We’re quite clear that we consider Fresh Del Monte Produce to be really rather risky, as a result of its debt. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. Given our hesitation about the stock, it would be good to know if Fresh Del Monte Produce insiders have sold any shares recently. You click here to find out if insiders have sold recently.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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. Thank you for reading.