David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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 Lamb Weston Holdings, Inc. (NYSE:LW) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
View our latest analysis for Lamb Weston Holdings
What Is Lamb Weston Holdings’s Net Debt?
The image below, which you can click on for greater detail, shows that at November 2020 Lamb Weston Holdings had debt of US$2.74b, up from US$2.24b in one year. On the flip side, it has US$763.9m in cash leading to net debt of about US$1.98b.
How Strong Is Lamb Weston Holdings’ Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Lamb Weston Holdings had liabilities of US$614.3m due within 12 months and liabilities of US$3.14b due beyond that. Offsetting this, it had US$763.9m in cash and US$353.2m in receivables that were due within 12 months. So it has liabilities totalling US$2.63b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Lamb Weston Holdings has a huge market capitalization of US$12.6b, 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.
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.
Lamb Weston Holdings’s debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 4.6 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. Shareholders should be aware that Lamb Weston Holdings’s EBIT was down 25% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Lamb Weston Holdings’s ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Lamb Weston Holdings recorded free cash flow worth 63% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Lamb Weston Holdings’s EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example, its conversion of EBIT to free cash flow is relatively strong. We think that Lamb Weston Holdings’s debt does make it a bit risky, after considering the aforementioned data points together. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For instance, we’ve identified 2 warning signs for Lamb Weston Holdings (1 can’t be ignored) you should be aware of.
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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