Some say volatility, rather than debt, is the best way to view risk as an investor, but Warren Buffett said “volatility is far from risk.” So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We notice that Kellogg Company (NYSE: K) has debt on its balance sheet. But the most important question is: what risk does this debt create?

What risk does debt entail?

Debt and other liabilities become risky for a business when it cannot easily meet these obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. Of course, many companies use debt to finance their growth without negative consequences. When we look at debt levels, we first consider both cash and debt levels.

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What is Kellogg’s net debt?

The image below, which you can click for more details, shows that Kellogg had US $ 7.71 billion in debt at the end of April 2021, a reduction from US $ 8.52 billion on a year. However, it has US $ 398.0 million in cash offsetting this, leading to net debt of around US $ 7.31 billion.

NYSE Debt to Equity History: K June 20, 2021

Is Kellogg’s Track Record Healthy?

The latest balance sheet data shows that Kellogg had liabilities of US $ 5.39 billion due within one year and liabilities of US $ 9.02 billion due thereafter. On the other hand, he had cash of US $ 398.0 million and receivables of US $ 1.66 billion within a year. Its liabilities therefore total $ 12.4 billion more than the combination of its cash and short-term receivables.

While that might sound like a lot, it’s not that bad since Kellogg has a massive market cap of US $ 21.7 billion, and could therefore likely strengthen its balance sheet by raising capital if needed. But we absolutely want to keep our eyes open for indications that its debt is too risky.

In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). The advantage of this approach is that we take into account both the absolute amount of debt (with net debt versus EBITDA) and the actual interest charges associated with this debt (with its coverage rate). interests).

Kellogg has a net debt on EBITDA of 3.1 which suggests that she is using a little leverage to increase returns. But the high interest coverage of 7.4 suggests that he can easily pay off that debt. If Kellogg can continue to grow his EBIT at the 11% rate last year compared to last year, then he will find his debt more manageable. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Kellogg can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

Finally, while the IRS may love accounting profits, lenders only accept hard cash. It is therefore worth checking to what extent this EBIT is supported by free cash flow. Over the past three years, Kellogg has generated strong free cash flow equivalent to 56% of its EBIT, roughly what we expected. This free cash flow puts the business in a good position to repay debt, if any.

Our point of view

Kellogg’s EBIT growth rate turned out to be very positive in this analysis, as did its interest coverage. On the other hand, its net debt to EBITDA makes us a little less comfortable with its debt. When we consider all of the factors mentioned above, we feel a little cautious about Kellogg’s use of debt. While we understand that debt can improve returns on equity, we suggest shareholders watch their debt level closely, lest they increase. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks lie on the balance sheet – far from it. Be aware that Kellogg displays 2 warning signs in our investment analysis , you must know…

At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.

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This Simply Wall St article is general in nature. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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