Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. 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 can see that Sodexo SA (EPA:SW) uses debt in its business. But should shareholders worry about its use of debt?
When is debt a problem?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we look at debt levels, we first consider cash and debt levels, together.
Check out our latest analysis for Sodexo
What is Sodexo’s debt?
As you can see below, at the end of February 2022, Sodexo had 5.66 billion euros in debt, compared to 5.06 billion euros a year ago. Click on the image for more details. On the other hand, it has €2.66 billion in cash, resulting in a net debt of around €3.00 billion.
A look at Sodexo’s liabilities
According to the last published balance sheet, Sodexo had liabilities of 8.90 billion euros at less than 12 months and liabilities of 7.13 billion euros at more than 12 months. In return, it had 2.66 billion euros in cash and 5.07 billion euros in receivables due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by €8.30 billion.
That’s a mountain of leverage, even compared to its gargantuan market cap of €10.4 billion. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet quickly.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Sodexo has a net debt to EBITDA ratio of 2.7, suggesting it uses good leverage to boost returns. On the positive side, its EBIT was 8.0 times its interest expense, and its net debt to EBITDA was quite high at 2.7. Fortunately, Sodexo is growing its EBIT faster than former Australian Prime Minister Bob Hawke dropped a yard glass, with a 631% gain over the last twelve months. 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 Sodexo’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, while the taxman may love accounting profits, lenders only accept cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Sodexo has recorded free cash flow representing 84% of its EBIT, which is higher than what we would normally expect. This positions him well to pay off debt if desired.
Our point of view
Sodexo’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 goalkeeper. But, on a darker note, we’re a bit concerned about his total passive level. Looking at all of the aforementioned factors together, it seems to us that Sodexo can manage its debt quite comfortably. On the plus side, this leverage can increase shareholder returns, but the potential downside is more risk of loss, so it’s worth keeping an eye on the balance sheet. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. These risks can be difficult to spot. Every business has them, and we’ve spotted 2 warning signs for Sodexo (1 of which can’t be ignored!) that you should know about.
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.