Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Lamb Weston Holdings, Inc. (NYSE:LW) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Lamb Weston Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that as of May 2024 Lamb Weston Holdings had US$3.82b of debt, an increase on US$3.45b, over one year. And it doesn't have much cash, so its net debt is about the same.

How Strong Is Lamb Weston Holdings' Balance Sheet?

We can see from the most recent balance sheet that Lamb Weston Holdings had liabilities of US$1.62b falling due within a year, and liabilities of US$3.96b due beyond that. On the other hand, it had cash of US$71.4m and US$743.6m worth of receivables due within a year. So its liabilities total US$4.76b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Lamb Weston Holdings has a market capitalization of US$8.75b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Lamb Weston Holdings has net debt to EBITDA of 2.7 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.2 times its interest expense, and its net debt to EBITDA, was quite high, at 2.7. Also relevant is that Lamb Weston Holdings has grown its EBIT by a very respectable 28% in the last year, thus enhancing its ability to pay down 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 Lamb Weston Holdings's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Lamb Weston Holdings created free cash flow amounting to 4.2% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

On our analysis Lamb Weston Holdings's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. When we consider all the factors mentioned above, we do feel a bit cautious about Lamb Weston Holdings's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Lamb Weston Holdings you should know about.

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

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.