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.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Conagra Brands, Inc. (NYSE:CAG) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Conagra Brands
What Is Conagra Brands’s Debt?
As you can see below, Conagra Brands had US$9.12b of debt at November 2020, down from US$10.3b a year prior. Net debt is about the same, since the it doesn’t have much cash.
A Look At Conagra Brands’ Liabilities
We can see from the most recent balance sheet that Conagra Brands had liabilities of US$3.35b falling due within a year, and liabilities of US$10.5b due beyond that. Offsetting these obligations, it had cash of US$68.0m as well as receivables valued at US$948.5m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$12.8b.
This is a mountain of leverage even relative to its gargantuan market capitalization of US$18.4b. 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).
Conagra Brands’s debt is 3.7 times its EBITDA, and its EBIT cover its interest expense 4.4 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 Conagra Brands could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 17%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Conagra Brands 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. During the last three years, Conagra Brands produced sturdy free cash flow equating to 57% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
While Conagra Brands’s net debt to EBITDA does give us pause, its EBIT growth rate and conversion of EBIT to free cash flow suggest it can stay on top of its debt load. We think that Conagra Brands’s debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. Case in point: We’ve spotted 2 warning signs for Conagra Brands you should be aware of.
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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