Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Hormel Foods Corporation (NYSE:HRL) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Hormel Foods Carry?
You can click the graphic below for the historical numbers, but it shows that as of July 2020 Hormel Foods had US$1.24b of debt, an increase on US$250.0m, over one year. But it also has US$1.75b in cash to offset that, meaning it has US$504.5m net cash.
How Strong Is Hormel Foods's Balance Sheet?
We can see from the most recent balance sheet that Hormel Foods had liabilities of US$1.43b falling due within a year, and liabilities of US$1.90b due beyond that. Offsetting this, it had US$1.75b in cash and US$649.6m in receivables that were due within 12 months. So it has liabilities totalling US$932.2m more than its cash and near-term receivables, combined.
Of course, Hormel Foods has a titanic market capitalization of US$27.7b, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Hormel Foods also has more cash than debt, so we're pretty confident it can manage its debt safely.
On the other hand, Hormel Foods saw its EBIT drop by 4.4% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hormel Foods 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Hormel Foods has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the most recent three years, Hormel Foods recorded free cash flow worth 75% 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.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Hormel Foods has US$504.5m in net cash. The cherry on top was that in converted 75% of that EBIT to free cash flow, bringing in US$862m. So is Hormel Foods's debt a risk? It doesn't seem so to us. 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. To that end, you should be aware of the 1 warning sign we've spotted with Hormel Foods .
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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