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David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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 Sonoco Products Company (NYSE:SON) does use debt in its business. But is this debt a concern to shareholders?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Sonoco Products’s Net Debt?
As you can see below, Sonoco Products had US$1.41b of debt, at March 2019, which is about the same the year before. You can click the chart for greater detail. On the flip side, it has US$124.3m in cash leading to net debt of about US$1.29b.
How Strong Is Sonoco Products’s Balance Sheet?
The latest balance sheet data shows that Sonoco Products had liabilities of US$1.16b due within a year, and liabilities of US$1.98b falling due after that. Offsetting this, it had US$124.3m in cash and US$870.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.15b.
While this might seem like a lot, it is not so bad since Sonoco Products has a market capitalization of US$6.52b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution. Either way, since Sonoco Products does have more debt than cash, it’s worth keeping an eye on its balance sheet.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
Sonoco Products’s net debt of 1.75 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 8.31 times interest expense) certainly does not do anything to dispel this impression. If Sonoco Products can keep growing EBIT at last year’s rate of 15% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Sonoco Products’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Sonoco Products produced sturdy free cash flow equating to 59% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
On this analysis, Sonoco Products’s EBIT growth rate was a real positive, just like an unsolicited gift of cupcakes from a work colleague. And its interest cover should also leave shareholders feeling frolicsome. All these things considered, it appears that Sonoco Products can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Sonoco Products insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.