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 Hormel Foods Corporation (NYSE:HRL) does use debt in its business. But is this debt a concern to shareholders?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company’s use of debt, we first look at cash and debt together.
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What Is Hormel Foods’ Net Debt?
The image below, which you can click on for greater detail, shows that at May 2022 Hormel Foods had debt of US$3.27b, up from US$993.0m in one year. However, it also had US$885.2m in cash, and so its net debt is US$2.39b.
How Healthy Is Hormel Foods’ Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Hormel Foods had liabilities of US$1.48b due within 12 months and liabilities of US$4.30b due beyond that. Offsetting this, it had US$885.2m in cash and US$803.1m in receivables that were due within 12 months. So its liabilities total US$4.09b more than the combination of its cash and short-term receivables.
Of course, Hormel Foods has a titanic market capitalization of US$26.7b, so these liabilities are probably manageable. Having said that, it’s clear that we should continue to monitor its balance sheet, not it change for the worse.
In order to size up a company’s debt relative to its, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
We’d say that Hormel Foods’s moderate net debt to EBITDA ratio ( being 1.6), indicates prudence when it comes to debt. And its strong interest cover of 38.7 times, makes us even more comfortable. Also good is that Hormel Foods grew its EBIT at 12% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Hormel Foods’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. During the last three years, Hormel Foods produced sturdy free cash flow equating to 67% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Hormel Foods’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Taking all this data into account, it seems to us that Hormel Foods takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We’d be motivated to research the stock further if we found out that Hormel Foods insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.