Is Sportsman's Warehouse Holdings (NASDAQ:SPWH) Using Too Much 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.' 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. As with many other companies Sportsman's Warehouse Holdings, Inc. (NASDAQ:SPWH) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Sportsman's Warehouse Holdings

What Is Sportsman's Warehouse Holdings's Net Debt?

As you can see below, at the end of October 2022, Sportsman's Warehouse Holdings had US$116.2m of debt, up from US$69.6m a year ago. Click the image for more detail. However, it does have US$2.56m in cash offsetting this, leading to net debt of about US$113.6m.

A Look At Sportsman's Warehouse Holdings' Liabilities

According to the last reported balance sheet, Sportsman's Warehouse Holdings had liabilities of US$376.7m due within 12 months, and liabilities of US$265.4m due beyond 12 months. Offsetting these obligations, it had cash of US$2.56m as well as receivables valued at US$1.69m due within 12 months. So its liabilities total US$637.8m more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the US$376.2m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Sportsman's Warehouse Holdings would likely require a major re-capitalisation if it had to pay its creditors today.

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.

Sportsman's Warehouse Holdings has a low net debt to EBITDA ratio of only 1.1. And its EBIT covers its interest expense a whopping 23.3 times over. So we're pretty relaxed about its super-conservative use of debt. In fact Sportsman's Warehouse Holdings's saving grace is its low debt levels, because its EBIT has tanked 41% in the last twelve months. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Sportsman's Warehouse Holdings can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Sportsman's Warehouse Holdings's free cash flow amounted to 46% 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 Sportsman's Warehouse Holdings's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We're quite clear that we consider Sportsman's Warehouse Holdings to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 4 warning signs with Sportsman's Warehouse Holdings (at least 1 which is significant) , and understanding them should be part of your investment process.

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.