Kellogg (NYSE:K) has a pretty healthy balance sheet

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Warren Buffett said: “Volatility is far from synonymous with risk. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Like many other companies Kellogg Company (NYSE:K) uses debt. 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. 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. Of course, many companies use debt to finance their growth, without any negative consequences. The first step when considering a company’s debt levels is to consider its cash and debt together.

What is Kellogg’s debt?

You can click on the chart below for historical numbers, but it shows Kellogg had $7.55 billion in debt in October 2021, up from $8.57 billion a year prior. However, he has $490.0 million in cash to offset this, resulting in a net debt of approximately $7.06 billion.

NYSE:K Debt to Equity January 12, 2022

How strong is Kellogg’s balance sheet?

We can see from the most recent balance sheet that Kellogg had liabilities of US$5.03 billion due in one year, and liabilities of US$9.37 billion due beyond. In compensation for these obligations, it had cash of US$490.0 million as well as receivables valued at US$1.68 billion and maturing within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables by $12.2 billion.

While that might sound like a lot, it’s not that bad since Kellogg has a huge market capitalization of US$22.7 billion, so it could probably bolster its balance sheet by raising capital if needed. But it is clear that it is essential to examine closely whether it can manage its debt without 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). Thus, we consider debt to earnings with and without amortization and depreciation expense.

With a net debt to EBITDA ratio of 3.0, Kellogg has a pretty notable amount of debt. But the high interest coverage of 8.1 suggests it can easily repay that debt. It is important to note that Kellogg’s EBIT has remained essentially stable over the past twelve months. 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 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, a business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Kellogg has had free cash flow of 59% of its EBIT, which is about normal given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.

Our point of view

Kellogg’s interest coverage was a real plus in this analysis, as was its conversion of EBIT to free cash flow. That said, its net debt to EBITDA makes us somewhat aware of potential future risks to the balance sheet. Looking at all this data, we feel a bit cautious about Kellogg’s debt levels. While we understand that debt can improve returns on equity, we suggest shareholders keep a close eye on their level of debt, lest it increase. 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. Example: we have identified 1 warning sign for Kellogg you should be aware.

If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.

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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.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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