Is SMART Global Holdings (NASDAQ:SGH) Using Too Much Debt?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, SMART Global Holdings, Inc. (NASDAQ:SGH) does carry debt. But is this debt a concern to shareholders?

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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for SMART Global Holdings

What Is SMART Global Holdings's Debt?

You can click the graphic below for the historical numbers, but it shows that SMART Global Holdings had US$740.7m of debt in March 2024, down from US$821.5m, one year before. However, it also had US$465.8m in cash, and so its net debt is US$274.9m.

A Look At SMART Global Holdings' Liabilities

Zooming in on the latest balance sheet data, we can see that SMART Global Holdings had liabilities of US$268.0m due within 12 months and liabilities of US$838.0m due beyond that. Offsetting these obligations, it had cash of US$465.8m as well as receivables valued at US$169.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$470.5m.

While this might seem like a lot, it is not so bad since SMART Global Holdings has a market capitalization of US$1.06b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While SMART Global Holdings has a quite reasonable net debt to EBITDA multiple of 2.3, its interest cover seems weak, at 1.3. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. Either way there's no doubt the stock is using meaningful leverage. Importantly, SMART Global Holdings's EBIT fell a jaw-dropping 46% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 SMART Global 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, SMART Global Holdings recorded free cash flow worth 78% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

Both SMART Global Holdings's EBIT growth rate and its interest cover were discouraging. But at least its conversion of EBIT to free cash flow is a gleaming silver lining to those clouds. When we consider all the factors discussed, it seems to us that SMART Global Holdings is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that SMART Global Holdings is showing 3 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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.