Stock Analysis

Is Sprouts Farmers Market (NASDAQ:SFM) Using Too Much Debt?

NasdaqGS:SFM
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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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Sprouts Farmers Market, Inc. (NASDAQ:SFM) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Our analysis indicates that SFM is potentially undervalued!

What Is Sprouts Farmers Market's Net Debt?

The chart below, which you can click on for greater detail, shows that Sprouts Farmers Market had US$250.0m in debt in July 2022; about the same as the year before. But on the other hand it also has US$289.2m in cash, leading to a US$39.2m net cash position.

debt-equity-history-analysis
NasdaqGS:SFM Debt to Equity History October 31st 2022

How Healthy Is Sprouts Farmers Market's Balance Sheet?

We can see from the most recent balance sheet that Sprouts Farmers Market had liabilities of US$515.3m falling due within a year, and liabilities of US$1.46b due beyond that. Offsetting this, it had US$289.2m in cash and US$13.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.67b.

While this might seem like a lot, it is not so bad since Sprouts Farmers Market has a market capitalization of US$3.19b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. While it does have liabilities worth noting, Sprouts Farmers Market also has more cash than debt, so we're pretty confident it can manage its debt safely.

On the other hand, Sprouts Farmers Market saw its EBIT drop by 6.0% in the last twelve months. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Sprouts Farmers Market 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, a company can only pay off debt with cold hard cash, not accounting profits. While Sprouts Farmers Market has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, Sprouts Farmers Market produced sturdy free cash flow equating to 78% 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.

Summing Up

Although Sprouts Farmers Market's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of US$39.2m. And it impressed us with free cash flow of US$280m, being 78% of its EBIT. So we don't have any problem with Sprouts Farmers Market's use of debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Sprouts Farmers Market (1 makes us a bit uncomfortable!) that you should be aware of before investing here.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

Valuation is complex, but we're helping make it simple.

Find out whether Sprouts Farmers Market is potentially over or undervalued by checking out our comprehensive analysis, which includes fair value estimates, risks and warnings, dividends, insider transactions and financial health.

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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.