We Think Nomad Foods (NYSE:NOMD) Is Taking Some Risk With Its Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We can see that Nomad Foods Limited (NYSE:NOMD) does use debt in its business. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Nomad Foods

What Is Nomad Foods's Debt?

The image below, which you can click on for greater detail, shows that Nomad Foods had debt of €2.04b at the end of September 2024, a reduction from €2.13b over a year. On the flip side, it has €334.4m in cash leading to net debt of about €1.70b.

How Healthy Is Nomad Foods' Balance Sheet?

We can see from the most recent balance sheet that Nomad Foods had liabilities of €1.02b falling due within a year, and liabilities of €2.78b due beyond that. Offsetting this, it had €334.4m in cash and €396.3m in receivables that were due within 12 months. So its liabilities total €3.07b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of €2.59b, we think shareholders really should watch Nomad Foods's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Nomad Foods has a debt to EBITDA ratio of 3.5 and its EBIT covered its interest expense 3.4 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Fortunately, Nomad Foods grew its EBIT by 4.0% in the last year, slowly shrinking its debt relative to earnings. 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 Nomad Foods'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Nomad Foods recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Nomad Foods's level of total liabilities was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its conversion of EBIT to free cash flow was re-invigorating. Taking the abovementioned factors together we do think Nomad Foods's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example - Nomad Foods has 1 warning sign we think you should be aware of.

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.