Central Garden & Pet (NASDAQ:CENT) Takes On Some Risk With Its Use Of 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Central Garden & Pet Company (NASDAQ:CENT) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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 CENT is potentially undervalued!

What Is Central Garden & Pet's Debt?

As you can see below, Central Garden & Pet had US$1.19b of debt, at June 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$195.8m in cash leading to net debt of about US$990.4m.

How Strong Is Central Garden & Pet's Balance Sheet?

We can see from the most recent balance sheet that Central Garden & Pet had liabilities of US$516.2m falling due within a year, and liabilities of US$1.48b due beyond that. On the other hand, it had cash of US$195.8m and US$505.9m worth of receivables due within a year. So its liabilities total US$1.29b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of US$1.93b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Central Garden & Pet has a debt to EBITDA ratio of 2.9 and its EBIT covered its interest expense 4.5 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Unfortunately, Central Garden & Pet saw its EBIT slide 5.8% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Central Garden & Pet's ability to maintain a healthy balance sheet going forward. 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 always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Central Garden & Pet recorded free cash flow of 44% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

At the end of the day, we're far from enamoured with Central Garden & Pet's ability to grow its EBIT or to handle its total liabilities. But at least its conversion of EBIT to free cash flow is not so bad. Once we consider all the factors above, together, it seems to us that Central Garden & Pet's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 1 warning sign for Central Garden & Pet 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.

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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.