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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. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Conagra Brands, Inc. (NYSE:CAG) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for Conagra Brands
What Is Conagra Brands's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of August 2019 Conagra Brands had US$10.4b of debt, an increase on US$3.85b, over one year. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Conagra Brands's Balance Sheet?
According to the last reported balance sheet, Conagra Brands had liabilities of US$2.45b due within 12 months, and liabilities of US$12.4b due beyond 12 months. Offsetting these obligations, it had cash of US$64.7m as well as receivables valued at US$776.3m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$14.0b.
Given this deficit is actually higher than the company's massive market capitalization of US$13.2b, we think shareholders really should watch Conagra Brands's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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).