Here's Why Central Garden & Pet (NASDAQ:CENT) Has A Meaningful Debt Burden

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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, Central Garden & Pet Company (NASDAQ:CENT) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. 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

What Is Central Garden & Pet's Debt?

As you can see below, Central Garden & Pet had US$1.19b of debt, at December 2022, which is about the same as the year before. You can click the chart for greater detail. However, it also had US$87.8m in cash, and so its net debt is US$1.10b.

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

According to the last reported balance sheet, Central Garden & Pet had liabilities of US$423.0m due within 12 months, and liabilities of US$1.48b due beyond 12 months. Offsetting these obligations, it had cash of US$87.8m as well as receivables valued at US$329.1m due within 12 months. So its liabilities total US$1.49b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of US$2.09b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Central Garden & Pet has a debt to EBITDA ratio of 3.5 and its EBIT covered its interest expense 4.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even more troubling is the fact that Central Garden & Pet actually let its EBIT decrease by 7.7% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. When analysing debt levels, the balance sheet is the obvious place to start. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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 27% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On this analysis Central Garden & Pet's EBIT growth rate and net debt to EBITDA both make us a little nervous. And its conversion of EBIT to free cash flow isn't much better. Overall, we think it's fair to say that Central Garden & Pet has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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 instance, we've identified 1 warning sign for Central Garden & Pet that you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.