Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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 can see that McCormick & Company, Incorporated (NYSE:MKC) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.
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How Much Debt Does McCormick Carry?
As you can see below, McCormick had US$5.21b of debt, at February 2023, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$356.8m in cash, and so its net debt is US$4.85b.
How Healthy Is McCormick’s Balance Sheet?
The latest balance sheet data shows that McCormick had liabilities of US$3.32b due within a year, and liabilities of US$5.00b falling due after that. On the other hand, it had cash of US$356.8m and US$571.0m worth of receivables due within a year. So its liabilities total US$7.39b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because McCormick is worth a massive US$24.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
McCormick’s debt is 4.4 times its EBITDA, and its EBIT cover its interest expense 6.2 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. Unfortunately, McCormick’s EBIT flopped 14% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if McCormick can strengthen its balance sheet over time. 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 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, McCormick produced sturdy free cash flow equating to 58% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Our View
While McCormick’s net debt to EBITDA makes us cautious about it, its track record of (not) growing its EBIT is no better. At least its conversion of EBIT to free cash flow gives us reason to be optimistic. Taking the abovementioned factors together we do think McCormick’s debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. Be aware that McCormick is showing 1 warning sign in our investment analysis , you should know about…
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.
