Simply Good Foods (NASDAQ:SMPL) Has A Pretty Healthy Balance Sheet

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.' 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. We can see that The Simply Good Foods Company (NASDAQ:SMPL) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Simply Good Foods

What Is Simply Good Foods's Net Debt?

The image below, which you can click on for greater detail, shows that Simply Good Foods had debt of US$272.0m at the end of November 2023, a reduction from US$396.9m over a year. However, it also had US$121.4m in cash, and so its net debt is US$150.6m.

How Healthy Is Simply Good Foods' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Simply Good Foods had liabilities of US$79.0m due within 12 months and liabilities of US$428.9m due beyond that. Offsetting this, it had US$121.4m in cash and US$135.6m in receivables that were due within 12 months. So its liabilities total US$250.9m more than the combination of its cash and short-term receivables.

Of course, Simply Good Foods has a market capitalization of US$3.44b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

With net debt sitting at just 0.66 times EBITDA, Simply Good Foods is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.8 times the interest expense over the last year. The good news is that Simply Good Foods has increased its EBIT by 5.2% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Simply Good Foods can strengthen its balance sheet over time. 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. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Simply Good Foods recorded free cash flow worth 70% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Simply Good Foods's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Taking all this data into account, it seems to us that Simply Good Foods takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Simply Good Foods insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.

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.