Is Grocery Outlet Holding (NASDAQ:GO) Using Too Much Debt?

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.' 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 note that Grocery Outlet Holding Corp. (NASDAQ:GO) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Grocery Outlet Holding

What Is Grocery Outlet Holding's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Grocery Outlet Holding had US$378.8m of debt in July 2022, down from US$450.3m, one year before. On the flip side, it has US$84.3m in cash leading to net debt of about US$294.5m.

How Healthy Is Grocery Outlet Holding's Balance Sheet?

We can see from the most recent balance sheet that Grocery Outlet Holding had liabilities of US$260.4m falling due within a year, and liabilities of US$1.38b due beyond that. Offsetting this, it had US$84.3m in cash and US$11.8m in receivables that were due within 12 months. So it has liabilities totalling US$1.54b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Grocery Outlet Holding is worth US$3.93b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Grocery Outlet Holding's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 5.7 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Unfortunately, Grocery Outlet Holding's EBIT flopped 17% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Grocery Outlet Holding 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Grocery Outlet Holding's free cash flow amounted to 47% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Grocery Outlet Holding's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to cover its interest expense with its EBIT isn't too shabby at all. When we consider all the factors discussed, it seems to us that Grocery Outlet Holding is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. To that end, you should be aware of the 2 warning signs we've spotted with Grocery Outlet Holding .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.