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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, The Simply Good Foods Company (NASDAQ:SMPL) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Simply Good Foods's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of August 2024 Simply Good Foods had US$397.5m of debt, an increase on US$281.6m, over one year. However, it does have US$132.5m in cash offsetting this, leading to net debt of about US$265.0m.

How Strong Is Simply Good Foods' Balance Sheet?

According to the last reported balance sheet, Simply Good Foods had liabilities of US$108.6m due within 12 months, and liabilities of US$600.0m due beyond 12 months. Offsetting this, it had US$132.5m in cash and US$150.7m in receivables that were due within 12 months. So it has liabilities totalling US$425.4m more than its cash and near-term receivables, combined.

Since publicly traded Simply Good Foods shares are worth a total of US$3.96b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

Simply Good Foods's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 10.5 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Simply Good Foods has increased its EBIT by 9.8% over twelve months, which should ease any concerns about debt repayment. 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 Simply Good Foods 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Simply Good Foods produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Simply Good Foods's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And the good news does not stop there, as its interest cover also supports that impression! Zooming out, Simply Good Foods seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Simply Good Foods is showing 1 warning sign in our investment analysis , you should know about...

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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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.