David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ 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. We can see that Post Holdings, Inc. (NYSE:POST) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.

What Is Post Holdings’s Debt?

The chart below, which you can click on for greater detail, shows that Post Holdings had US$7.42b in debt in September 2021; about the same as the year before. However, it does have US$817.1m in cash offsetting this, leading to net debt of about US$6.60b.

How Healthy Is Post Holdings’ Balance Sheet?

According to the last reported balance sheet, Post Holdings had liabilities of US$1.05b due within 12 months, and liabilities of US$8.31b due beyond 12 months. Offsetting these obligations, it had cash of US$817.1m as well as receivables valued at US$553.9m due within 12 months. So it has liabilities totalling US$7.98b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company’s market capitalization of US$7.14b, we think shareholders really should watch Post Holdings’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Post Holdings has a rather high debt to EBITDA ratio of 6.1 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 2.7 times, suggesting it can responsibly service its obligations. Given the debt load, it’s hardly ideal that Post Holdings’s EBIT was pretty flat over the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Post Holdings’s ability to maintain a healthy balance sheet going forward.

Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Post Holdings recorded free cash flow worth 56% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

We’d go so far as to say Post Holdings’s net debt to EBITDA was disappointing. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Overall, we think it’s fair to say that Post Holdings has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt.