We Think Central Garden & Pet (NASDAQ:CENT) Is Taking Some Risk With Its Debt

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.' 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 note that Central Garden & Pet Company (NASDAQ:CENT) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

See our latest analysis for Central Garden & Pet

What Is Central Garden & Pet's Net Debt?

The chart below, which you can click on for greater detail, shows that Central Garden & Pet had US$1.19b in debt in June 2023; about the same as the year before. However, it also had US$333.1m in cash, and so its net debt is US$854.6m.

A Look At Central Garden & Pet's Liabilities

The latest balance sheet data shows that Central Garden & Pet had liabilities of US$496.4m due within a year, and liabilities of US$1.48b falling due after that. On the other hand, it had cash of US$333.1m and US$492.9m worth of receivables due within a year. So it has liabilities totalling US$1.15b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Central Garden & Pet is worth US$2.13b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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 2.7 and its EBIT covered its interest expense 4.2 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 9.3% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Central Garden & Pet's free cash flow amounted to 48% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While Central Garden & Pet's interest cover makes us cautious about it, its track record of (not) growing its EBIT is no better. But its not so bad at converting EBIT to free cash flow. When we consider all the factors discussed, it seems to us that Central Garden & Pet is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Central Garden & Pet you should know about.

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.