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.' 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. We can see that Central Garden & Pet Company (NASDAQ:CENT) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Central Garden & Pet

How Much Debt Does Central Garden & Pet Carry?

The chart below, which you can click on for greater detail, shows that Central Garden & Pet had US$1.21b in debt in March 2023; about the same as the year before. However, because it has a cash reserve of US$60.6m, its net debt is less, at about US$1.15b.

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

The latest balance sheet data shows that Central Garden & Pet had liabilities of US$475.9m due within a year, and liabilities of US$1.50b falling due after that. Offsetting these obligations, it had cash of US$60.6m as well as receivables valued at US$564.9m due within 12 months. So it has liabilities totalling US$1.35b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of US$1.91b, so it does suggest shareholders should keep an eye on Central Garden & Pet's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Central Garden & Pet's debt is 3.9 times its EBITDA, and its EBIT cover its interest expense 3.6 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Worse, Central Garden & Pet's EBIT was down 21% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Central Garden & Pet 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, Central Garden & Pet's free cash flow amounted to 32% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Mulling over Central Garden & Pet's attempt at (not) growing its EBIT, we're certainly not enthusiastic. And even its level of total liabilities fails to inspire much confidence. We're quite clear that we consider Central Garden & Pet to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Central Garden & Pet that you should be aware of.

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.