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.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that Coca-Cola Consolidated, Inc. (NASDAQ:COKE) does use debt in its business. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
See our latest analysis for Coca-Cola Consolidated
What Is Coca-Cola Consolidated’s Debt?
The image below, which you can click on for greater detail, shows that Coca-Cola Consolidated had debt of US$962.9m at the end of September 2020, a reduction from US$1.03b over a year. However, it does have US$164.8m in cash offsetting this, leading to net debt of about US$798.0m.
How Healthy Is Coca-Cola Consolidated’s Balance Sheet?
The latest balance sheet data shows that Coca-Cola Consolidated had liabilities of US$684.0m due within a year, and liabilities of US$2.07b falling due after that. Offsetting these obligations, it had cash of US$164.8m as well as receivables valued at US$527.4m due within 12 months. So its liabilities total US$2.06b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of US$2.50b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Coca-Cola Consolidated’s net debt is sitting at a very reasonable 1.9 times its EBITDA, while its EBIT covered its interest expense just 6.4 times last year. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. Importantly, Coca-Cola Consolidated grew its EBIT by 88% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can’t view debt in total isolation; since Coca-Cola Consolidated will need earnings to service that debt. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Coca-Cola Consolidated actually produced more free cash flow than EBIT over the last three years. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
Coca-Cola Consolidated’s conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. But, on a more sombre note, we are a little concerned by its level of total liabilities. All these things considered, it appears that Coca-Cola Consolidated 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. 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. Be aware that Coca-Cola Consolidated is showing 3 warning signs in our investment analysis , and 1 of those is significant…
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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