We Think Sonoco Products (NYSE:SON) 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.' 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. We can see that Sonoco Products Company (NYSE:SON) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Sonoco Products

What Is Sonoco Products's Net Debt?

The chart below, which you can click on for greater detail, shows that Sonoco Products had US$3.05b in debt in July 2023; about the same as the year before. However, because it has a cash reserve of US$319.2m, its net debt is less, at about US$2.74b.

How Healthy Is Sonoco Products' Balance Sheet?

We can see from the most recent balance sheet that Sonoco Products had liabilities of US$1.52b falling due within a year, and liabilities of US$3.23b due beyond that. On the other hand, it had cash of US$319.2m and US$1.01b worth of receivables due within a year. So it has liabilities totalling US$3.42b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of US$5.32b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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 a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 6.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Sonoco Products grew its EBIT by 6.2% in the last year. That's far from incredible but it is a good thing, when it comes to paying off 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 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 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. In the last two years, Sonoco Products's free cash flow amounted to 29% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Both Sonoco Products's level of total liabilities and its conversion of EBIT to free cash flow were discouraging. At least its EBIT growth rate gives us reason to be optimistic. 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Sonoco Products that you should be aware of before investing here.

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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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.