These 4 Measures Indicate That Scotts Miracle-Gro (NYSE:SMG) Is Using Debt In A Risky Way

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 The Scotts Miracle-Gro Company (NYSE:SMG) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Scotts Miracle-Gro

What Is Scotts Miracle-Gro's Debt?

The image below, which you can click on for greater detail, shows that Scotts Miracle-Gro had debt of US$3.06b at the end of July 2023, a reduction from US$3.45b over a year. Net debt is about the same, since the it doesn't have much cash.

How Healthy Is Scotts Miracle-Gro's Balance Sheet?

The latest balance sheet data shows that Scotts Miracle-Gro had liabilities of US$1.33b due within a year, and liabilities of US$2.99b falling due after that. Offsetting these obligations, it had cash of US$43.7m as well as receivables valued at US$1.16b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.12b.

Given this deficit is actually higher than the company's market capitalization of US$2.61b, we think shareholders really should watch Scotts Miracle-Gro's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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.

Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 6.5 hit our confidence in Scotts Miracle-Gro like a one-two punch to the gut. The debt burden here is substantial. Worse, Scotts Miracle-Gro's EBIT was down 20% 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 Scotts Miracle-Gro 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Scotts Miracle-Gro's free cash flow amounted to 21% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both Scotts Miracle-Gro's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And even its level of total liabilities fails to inspire much confidence. Taking into account all the aforementioned factors, it looks like Scotts Miracle-Gro has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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 example, we've discovered 3 warning signs for Scotts Miracle-Gro (1 doesn't sit too well with us!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.