Is Nomad Foods (NYSE:NOMD) using too much debt?

Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. 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 note that Nomad Foods Limited (NYSE:NOMD) has debt on its balance sheet. But the more important question is: what risk does this debt create?

What risk does debt carry?

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. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. 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. When we look at debt levels, we first consider cash and debt levels, together.

See our latest analysis for Nomad Foods

How much debt does Nomad Foods have?

As you can see below, at the end of March 2022, Nomad Foods had €2.16 billion in debt, up from €1.78 billion a year ago. Click on the image for more details. However, because it has a cash reserve of €255.8m, its net debt is lower, at around €1.91bn.

NYSE: NOMD Debt to Equity History July 2, 2022

How strong is Nomad Foods’ balance sheet?

We can see from the most recent balance sheet that Nomad Foods had liabilities of 1.00 billion euros due in one year, and liabilities of 2.88 billion euros beyond that. In return for these obligations, it had cash of €255.8 million as well as receivables worth €288.3 million at less than 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by €3.33 billion.

That’s a mountain of leverage compared to its market capitalization of 3.35 billion euros. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant dilution.

We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.

Nomad Foods has a debt to EBITDA ratio of 4.2 and its EBIT covered its interest expense 6.5 times. This suggests that while debt levels are significant, we will refrain from labeling them problematic. Notably, Nomad Foods’ EBIT has been fairly stable over the past year. We would prefer to see some earnings growth as this always helps reduce debt. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether Nomad Foods 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.

But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Nomad Foods has produced strong free cash flow equivalent to 76% of its EBIT, which is what we expected. This cold hard cash allows him to reduce his debt whenever he wants.

Our point of view

Neither Nomad Foods’ ability to manage its debt, on an EBITDA basis, nor its level of total liabilities gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story and suggests some resilience. Looking at all the angles discussed above, it does seem to us that Nomad Foods is a somewhat risky investment due to its leverage. Not all risk is bad, as it can boost stock returns if it pays off, but this leverage risk is worth keeping in mind. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, we found 2 warning signs for Nomad Foods (1 makes us a little uneasy!) that you should be aware of before investing here.

If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.

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.

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