SMART Global Holdings (NASDAQ:SGH) Has A Somewhat Strained Balance Sheet

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.' 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. We can see that SMART Global Holdings, Inc. (NASDAQ:SGH) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for SMART Global Holdings

What Is SMART Global Holdings's Net Debt?

As you can see below, at the end of May 2023, SMART Global Holdings had US$814.5m of debt, up from US$493.8m a year ago. Click the image for more detail. However, it does have US$401.3m in cash offsetting this, leading to net debt of about US$413.2m.

A Look At SMART Global Holdings' Liabilities

We can see from the most recent balance sheet that SMART Global Holdings had liabilities of US$384.3m falling due within a year, and liabilities of US$882.7m due beyond that. On the other hand, it had cash of US$401.3m and US$263.4m worth of receivables due within a year. So its liabilities total US$602.4m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because SMART Global Holdings is worth US$1.33b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

SMART Global Holdings has a debt to EBITDA ratio of 2.7 and its EBIT covered its interest expense 2.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Worse, SMART Global Holdings's EBIT was down 59% 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. 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'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, SMART Global Holdings produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

We'd go so far as to say SMART Global Holdings's EBIT growth rate was disappointing. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. Once we consider all the factors above, together, it seems to us that SMART Global Holdings's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example SMART Global Holdings has 2 warning signs (and 1 which is significant) we think 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.