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. 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 Grocery Outlet Holding Corp. (NASDAQ:GO) 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?
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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Grocery Outlet Holding's Debt?
The image below, which you can click on for greater detail, shows that Grocery Outlet Holding had debt of US$462.4m at the end of June 2019, a reduction from US$710.9m over a year. However, it also had US$18.7m in cash, and so its net debt is US$443.7m.
How Healthy Is Grocery Outlet Holding's Balance Sheet?
The latest balance sheet data shows that Grocery Outlet Holding had liabilities of US$176.3m due within a year, and liabilities of US$1.19b falling due after that. Offsetting this, it had US$18.7m in cash and US$8.50m in receivables that were due within 12 months. So its liabilities total US$1.34b more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Grocery Outlet Holding has a market capitalization of US$3.31b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Grocery Outlet Holding's debt to EBITDA ratio (3.8) suggests that it uses some debt, its interest cover is very weak, at 1.1, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Another concern for investors might be that Grocery Outlet Holding's EBIT fell 18% in the last year. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Grocery Outlet Holding's ability to maintain a healthy balance sheet going forward. 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, Grocery Outlet Holding reported free cash flow worth 18% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
To be frank both Grocery Outlet Holding's EBIT growth rate and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. Having said that, its ability to handle its total liabilities isn't such a worry. Overall, it seems to us that Grocery Outlet Holding's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Given our hesitation about the stock, it would be good to know if Grocery Outlet Holding insiders have sold any shares recently. You click here to find out if insiders have sold recently.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.