Warren Buffett said: “Volatility is far from synonymous with risk. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We can see that The Middleby Company (NASDAQ:MIDD) uses debt in its business. But the more important question is: what risk does this debt create?
Why is debt risky?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. If things go really bad, lenders can take over the business. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. The first step when considering a company’s debt levels is to consider its cash and debt together.
What is Middleby’s net debt?
The graph below, which you can click on for more details, shows that Middleby had $1.92 billion in debt as of October 2021; about the same as the previous year. However, he has $251.5 million in cash to offset this, resulting in a net debt of approximately $1.67 billion.
How strong is Middleby’s balance sheet?
We can see from the most recent balance sheet that Middleby had liabilities of US$822.8 million maturing in one year, and liabilities of US$2.65 billion due beyond. In return, he had $251.5 million in cash and $487.4 million in receivables due within 12 months. Thus, its liabilities outweigh the sum of its cash and (current) receivables by $2.73 billion.
While that might sound like a lot, it’s not that bad since Middleby has a huge market capitalization of US$11.1 billion, so it could probably bolster its balance sheet by raising capital if needed. However, it is always worth taking a close look at your ability to repay debt.
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). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Middleby’s net debt of 2.5x EBITDA suggests judicious use of debt. And the fact that its last twelve months of EBIT was 8.5 times its interest expense aligns with that theme. Above all, Middleby has increased its EBIT by 35% over the last twelve months, and this growth will make it easier to manage its debt. The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine Middleby’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecasts.
Finally, a company can only repay its debts with cold hard cash, not with book profits. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Middleby has recorded free cash flow of 81% of its EBIT, which is higher than we would normally expect. This positions him well to pay off debt if desired.
Our point of view
Middleby’s conversion of EBIT to free cash flow suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 keeper. But truth be told, we think its net debt to EBITDA somewhat undermines that impression. Overall, we think Middleby’s use of debt seems entirely reasonable and we’re not worried about that. After all, reasonable leverage can increase return on equity. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 2 warning signs for Middleby you should know.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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