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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that McCormick & Company, Incorporated (NYSE:MKC) does use debt in its business. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

What Is McCormick's Debt?

The image below, which you can click on for greater detail, shows that McCormick had debt of US$4.51b at the end of February 2024, a reduction from US$5.21b over a year. However, it does have US$178.0m in cash offsetting this, leading to net debt of about US$4.33b.

A Look At McCormick's Liabilities

The latest balance sheet data shows that McCormick had liabilities of US$2.97b due within a year, and liabilities of US$4.66b falling due after that. Offsetting this, it had US$178.0m in cash and US$567.5m in receivables that were due within 12 months. So its liabilities total US$6.89b more than the combination of its cash and short-term receivables.

McCormick has a very large market capitalization of US$19.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

McCormick has a debt to EBITDA ratio of 3.5 and its EBIT covered its interest expense 6.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. One way McCormick could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 13%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if McCormick can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, McCormick produced sturdy free cash flow equating to 68% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

McCormick's conversion of EBIT to free cash flow was a real positive on this analysis, as was its EBIT growth rate. On the other hand, its net debt to EBITDA makes us a little less comfortable about its debt. Considering this range of data points, we think McCormick is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for McCormick that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.