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. We can see that Central Garden & Pet Company (NASDAQ:CENT) does use debt in its business. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Central Garden & Pet's Debt?

As you can see below, Central Garden & Pet had US$1.19b of debt, at December 2023, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$341.4m in cash offsetting this, leading to net debt of about US$848.1m.

A Look At Central Garden & Pet's Liabilities

Zooming in on the latest balance sheet data, we can see that Central Garden & Pet had liabilities of US$494.2m due within 12 months and liabilities of US$1.48b due beyond that. Offsetting these obligations, it had cash of US$341.4m as well as receivables valued at US$371.0m due within 12 months. So its liabilities total US$1.26b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Central Garden & Pet has a market capitalization of US$2.27b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Central Garden & Pet has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 5.3 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Central Garden & Pet grew its EBIT by 3.3% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Central Garden & Pet's ability to maintain a healthy balance sheet going forward. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Central Garden & Pet's free cash flow amounted to 45% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Both Central Garden & Pet's level of total liabilities and its net debt to EBITDA were discouraging. At least its EBIT growth rate gives us reason to be optimistic. We think that Central Garden & Pet's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 1 warning sign for Central Garden & Pet that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.