Is Potbelly (NASDAQ:PBPB) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, Potbelly Corporation (NASDAQ:PBPB) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Potbelly

What Is Potbelly's Debt?

As you can see below, Potbelly had US$4.00m of debt at June 2024, down from US$22.4m a year prior. However, its balance sheet shows it holds US$8.32m in cash, so it actually has US$4.32m net cash.

How Strong Is Potbelly's Balance Sheet?

According to the last reported balance sheet, Potbelly had liabilities of US$62.9m due within 12 months, and liabilities of US$144.0m due beyond 12 months. Offsetting these obligations, it had cash of US$8.32m as well as receivables valued at US$8.97m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$189.6m.

This deficit is considerable relative to its market capitalization of US$229.7m, so it does suggest shareholders should keep an eye on Potbelly's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, Potbelly boasts net cash, so it's fair to say it does not have a heavy debt load!

On top of that, Potbelly grew its EBIT by 37% over the last twelve months, and that growth will make it easier to handle its 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 Potbelly's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. Potbelly may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last two years, Potbelly reported free cash flow worth 12% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Summing Up

Although Potbelly'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$4.32m. And it impressed us with its EBIT growth of 37% over the last year. So we don't have any problem with Potbelly's use of debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example Potbelly has 2 warning signs (and 1 which can't be ignored) we think you should know about.

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.