Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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 Nomad Foods Limited (NYSE:NOMD) does use debt in its business. 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. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. 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 Nomad Foods
What Is Nomad Foods’s Debt?
The chart below, which you can click on for greater detail, shows that Nomad Foods had €1.79b in debt in December 2020; about the same as the year before. However, it also had €418.2m in cash, and so its net debt is €1.37b.
How Strong Is Nomad Foods’ Balance Sheet?
The latest balance sheet data shows that Nomad Foods had liabilities of €916.3m due within a year, and liabilities of €2.53b falling due after that. Offsetting this, it had €418.2m in cash and €175.8m in receivables that were due within 12 months. So its liabilities total €2.85b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of €3.50b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Nomad Foods’s debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 6.4 times over. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. One way Nomad Foods could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Nomad Foods’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 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. During the last three years, Nomad Foods generated free cash flow amounting to a very robust 93% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.
When it comes to the balance sheet, the standout positive for Nomad Foods was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren’t so heartening. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Nomad Foods is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. To that end, you should be aware of the 1 warning sign we’ve spotted with Nomad Foods .
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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