Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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 McCormick & Company, Incorporated (NYSE:MKC) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is McCormick's Debt?
You can click the graphic below for the historical numbers, but it shows that as of August 2021 McCormick had US$5.52b of debt, an increase on US$4.05b, over one year. However, it does have US$312.6m in cash offsetting this, leading to net debt of about US$5.21b.
A Look At McCormick's Liabilities
The latest balance sheet data shows that McCormick had liabilities of US$3.16b due within a year, and liabilities of US$5.32b falling due after that. On the other hand, it had cash of US$312.6m and US$541.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.63b.
While this might seem like a lot, it is not so bad since McCormick has a huge market capitalization of US$21.7b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
McCormick has net debt to EBITDA of 4.1 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.5 times its interest expense, and its net debt to EBITDA, was quite high, at 4.1. McCormick grew its EBIT by 4.5% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine McCormick's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, McCormick produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
McCormick's conversion of EBIT to free cash flow was a real positive on this analysis, as was its interest cover. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think McCormick is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For example, we've discovered 1 warning sign for McCormick that you should be aware of before investing here.
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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