Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, MGP Ingredients, Inc. (NASDAQ:MGPI) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is MGP Ingredients’s Debt?
The image below, which you can click on for greater detail, shows that at December 2021 MGP Ingredients had debt of US$233.4m, up from US$39.9m in one year. However, it also had US$21.6m in cash, and so its net debt is US$211.8m.
How Strong Is MGP Ingredients’ Balance Sheet?
The latest balance sheet data shows that MGP Ingredients had liabilities of US$88.8m due within a year, and liabilities of US$308.4m falling due after that. Offsetting this, it had US$21.6m in cash and US$98.1m in receivables that were due within 12 months. So its liabilities total US$277.6m more than the combination of its cash and short-term receivables.
Given MGP Ingredients has a market capitalization of US$1.97b, it’s hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
MGP Ingredients’s net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its strong interest cover of 24.2 times, makes us even more comfortable. Importantly, MGP Ingredients grew its EBIT by 93% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine MGP Ingredients’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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, MGP Ingredients’s free cash flow amounted to 40% of its EBIT, less than we’d expect. That weak cash conversion makes it more difficult to handle indebtedness.
MGP Ingredients’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And that’s just the beginning of the good news since its EBIT growth rate is also very heartening. When we consider the range of factors above, it looks like MGP Ingredients is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start.