How Safe Is Your Money In Diageo plc?

Global spirits giant Diageo (LSE: DGE) (NYSE: DEO.US) owns some of the most popular brands in the world. Names such as Guinness, Johnnie Walker and Smirnoff are a core part of its business — but its rapid growth over the last decade has burdened it with a sizeable chunk of debt.

Diageo’s earnings are now showing signs of slowing, so I’ve taken a look at three of the firm’s key financial ratios, to see how safe Diageo’s dividend looks and whether investors should be concerned by the firm’s high debt levels.

1. Operating profit/interest

What we’re looking for here is a ratio of at least 1.5, preferably over 2, to show that Diageo’s earnings cover its interest payments with room to spare:

Operating Profit / interest paid

£3,454m / £440m = 7.9 times cover

Diageo’s enviable brand portfolio gives it strong pricing power, which in turn enables it to maintain a high level of interest cover, despite above-average debt levels.

diageoI don’t think that Diageo’s interest payments are likely to threaten its dividend in the foreseeable future, but there are some risks, as I’ll explain below.

2. Debt/equity ratio

Commonly referred to as gearing, this is simply the ratio of debt to shareholder equity, or book value (total assets – total liabilities). I tend to use net debt, as companies often maintain large cash balances that can be used to reduce debt if necessary.

At the end of 2013, Diageo reported net debt of £8,832m and equity of £8,038m, giving net gearing of 110%. This is higher than I like to see, but balancing this risk is Diageo’s proven ability to integrate its acquisitions successfully.

3. Operating profit/sales

This ratio is usually known as operating margin and is useful measure of a company’s profitability.

Diageo has reported an operating margin of 22.5% over the last twelve months, or 30% if you exclude the excise duties it pays on its sales. These margins highlight the pricing power of Diageo’s brands, which have enjoyed strong sales throughout the financial crisis.

Diageo’s high operating margin means that its earnings per share cover its dividend more than two times, a comfortable ratio. However, the firm’s continued investment in acquisitions means that Diageo’s free cash flow has not covered its dividend since 2008 — one reason I believe it should place a little more emphasis on debt reduction and cash generation going forwards.

Is Diageo a safe buy?

Diageo is undoubtedly a great company, and it's been on my personal watch list for a long time. I've avoided hitting the buy button due to the firm's low yield and full valuation, but not everyone has agreed with this decision.

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Roland does not own shares in Diageo.