The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Fresh Del Monte Produce Inc. (NYSE:FDP) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

How Much Debt Does Fresh Del Monte Produce Carry?

The image below, which you can click on for greater detail, shows that Fresh Del Monte Produce had debt of US$570.9m at the end of April 2021, a reduction from US$653.2m over a year. On the flip side, it has US$26.4m in cash leading to net debt of about US$544.5m.

How Strong Is Fresh Del Monte Produce’s Balance Sheet?

We can see from the most recent balance sheet that Fresh Del Monte Produce had liabilities of US$598.7m falling due within a year, and liabilities of US$966.3m due beyond that. Offsetting this, it had US$26.4m in cash and US$469.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.07b.

This deficit is considerable relative to its market capitalization of US$1.49b, so it does suggest shareholders should keep an eye on Fresh Del Monte Produce’s use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Fresh Del Monte Produce’s net debt is sitting at a very reasonable 2.5 times its EBITDA, while its EBIT covered its interest expense just 6.1 times last year. While these numbers do not alarm us, it’s worth noting that the cost of the company’s debt is having a real impact. It is well worth noting that Fresh Del Monte Produce’s EBIT shot up like bamboo after rain, gaining 61% in the last twelve months. That’ll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Fresh Del Monte Produce’s ability to maintain a healthy balance sheet going forward.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, Fresh Del Monte Produce generated free cash flow amounting to a very robust 84% of its EBIT, more than we’d expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, Fresh Del Monte Produce’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. All these things considered, it appears that Fresh Del Monte Produce can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start.