Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We note that Britvic plc (LON:BVIC) has debt on its balance sheet. But should shareholders worry about its use of debt?
Why is debt risky?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. If things go really bad, lenders can take over the business. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
See our latest review for Britvic
What is Britvic’s debt?
The image below, which you can click on for more details, shows Britvic had £580.4m in debt at the end of March 2022, a reduction from £628.9m year on year . However, he also had £29.9m in cash, so his net debt is £550.5m.
How healthy is Britvic’s balance sheet?
Zooming in on the latest balance sheet data, we can see that Britvic had liabilities of £609.1m due within 12 months and liabilities of £731.5m due beyond. On the other hand, it had cash of £29.9 million and £397.1 million of receivables due within a year. It therefore has liabilities totaling £913.6 million more than its cash and short-term receivables, combined.
This shortfall is not that bad as Britvic is worth £2.15bn and could therefore probably raise enough capital to shore up its balance sheet, should the need arise. But we definitely want to keep our eyes peeled for indications that its debt is too risky.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Britvic’s net debt to EBITDA ratio of around 2.5 suggests only moderate use of debt. And its strong interest coverage of 10.8 times makes us even more comfortable. It should be noted that Britvic’s EBIT has jumped like bamboo after rain, gaining 43% over the last twelve months. This will make it easier to manage your debt. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Britvic’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Britvic has generated free cash flow of a very strong 93% of its EBIT, more than we expected. This puts him in a very strong position to repay his debt.
Our point of view
Fortunately, Britvic’s impressive EBIT to free cash flow conversion means it has the upper hand on its debt. But truth be told, we think its net debt to EBITDA somewhat undermines that impression. Overall, we think Britvic’s use of debt seems entirely reasonable and we’re not worried about that. After all, reasonable leverage can increase return on equity. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. We have identified 2 warning signs with Britvic, and understanding them should be part of your investment process.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.