Sonoco Products (NYSE:SON) Takes On Some Risk With Its Use Of Debt

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Sonoco Products Company (NYSE:SON) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Sonoco Products

How Much Debt Does Sonoco Products Carry?

You can click the graphic below for the historical numbers, but it shows that as of October 2022 Sonoco Products had US$3.04b of debt, an increase on US$1.42b, over one year. On the flip side, it has US$182.2m in cash leading to net debt of about US$2.85b.

A Look At Sonoco Products' Liabilities

Zooming in on the latest balance sheet data, we can see that Sonoco Products had liabilities of US$1.76b due within 12 months and liabilities of US$3.29b due beyond that. On the other hand, it had cash of US$182.2m and US$1.09b worth of receivables due within a year. So its liabilities total US$3.77b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of US$5.97b, so it does suggest shareholders should keep an eye on Sonoco Products' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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).

Sonoco Products has net debt to EBITDA of 2.7 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 9.4 times its interest expense, and its net debt to EBITDA, was quite high, at 2.7. We also note that Sonoco Products improved its EBIT from a last year's loss to a positive US$761m. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sonoco Products 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Sonoco Products reported free cash flow worth 8.5% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Sonoco Products's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Sonoco Products is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Sonoco Products (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

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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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.