These 4 Measures Indicate That Lamb Weston Holdings (NYSE:LW) Is Using Debt Reasonably Well

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.' 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 can see that Lamb Weston Holdings, Inc. (NYSE:LW) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Lamb Weston Holdings

How Much Debt Does Lamb Weston Holdings Carry?

As you can see below, at the end of May 2023, Lamb Weston Holdings had US$3.45b of debt, up from US$2.72b a year ago. Click the image for more detail. However, because it has a cash reserve of US$304.8m, its net debt is less, at about US$3.15b.

How Healthy Is Lamb Weston Holdings' Balance Sheet?

According to the last reported balance sheet, Lamb Weston Holdings had liabilities of US$1.36b due within 12 months, and liabilities of US$3.75b due beyond 12 months. Offsetting these obligations, it had cash of US$304.8m as well as receivables valued at US$724.2m due within 12 months. So it has liabilities totalling US$4.08b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Lamb Weston Holdings has a huge market capitalization of US$14.2b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With net debt to EBITDA of 2.9 Lamb Weston Holdings has a fairly noticeable amount of debt. On the plus side, its EBIT was 7.9 times its interest expense, and its net debt to EBITDA, was quite high, at 2.9. It is well worth noting that Lamb Weston Holdings's EBIT shot up like bamboo after rain, gaining 94% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Lamb Weston Holdings 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Lamb Weston Holdings recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On our analysis Lamb Weston Holdings's EBIT growth rate 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 elements mentioned above, it seems to us that Lamb Weston Holdings is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Lamb Weston Holdings is showing 3 warning signs in our investment analysis , and 2 of those are a bit unpleasant...

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.

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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.