Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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 note that Kellogg Company (NYSE:K) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, 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.
View our latest analysis for Kellogg
What Is Kellogg’s Net Debt?
The image below, which you can click on for greater detail, shows that Kellogg had debt of US$7.71b at the end of April 2021, a reduction from US$8.52b over a year. However, it does have US$398.0m in cash offsetting this, leading to net debt of about US$7.31b.
How Healthy Is Kellogg’s Balance Sheet?
The latest balance sheet data shows that Kellogg had liabilities of US$5.39b due within a year, and liabilities of US$9.02b falling due after that. On the other hand, it had cash of US$398.0m and US$1.66b worth of receivables due within a year. So its liabilities total US$12.4b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Kellogg has a huge market capitalization of US$21.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).
Kellogg has net debt to EBITDA of 3.1 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.4 suggests it can easily service that debt. If Kellogg can keep growing EBIT at last year’s rate of 11% over the last year, then it will find its debt load easier to manage. 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 Kellogg 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, 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. During the last three years, Kellogg produced sturdy free cash flow equating to 56% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Kellogg’s EBIT growth rate was a real positive on this analysis, as was its interest cover. On the other hand, its net debt to EBITDA makes us a little less comfortable about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Kellogg’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. Be aware that Kellogg is showing 2 warning signs in our investment analysis , you should know about…
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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