Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We note that Simply Good Foods Company (NASDAQ:SMPL) has debt on its balance sheet. But the more important question is: what risk does this debt create?

When is debt dangerous?

Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more frequent (but still costly) event is when a company has to issue shares at bargain prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, many companies use debt to finance their growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.

Check out our latest analysis for Simply Good Foods

What is Simply Good Foods’ net debt?

The image below, which you can click on for more details, shows Simply Good Foods had $426.7 million in debt at the end of February 2022, a reduction from $548.3 million year-over-year . However, he has $51.5 million in cash to offset this, resulting in a net debt of approximately $375.2 million.

A look at the responsibilities of Simply Good Foods

Zooming in on the latest balance sheet data, we can see that Simply Good Foods had liabilities of US$107.7 million due within 12 months and liabilities of US$579.2 million due beyond. In return, he had $51.5 million in cash and $118.2 million in receivables due within 12 months. It therefore has liabilities totaling $517.2 million more than its cash and short-term receivables, combined.

Given that Simply Good Foods has a market capitalization of US$4.12 billion, it’s hard to believe that these liabilities pose much of a threat. That said, it is clear that we must continue to monitor its record, lest it deteriorate.

We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). Thus, we consider debt to earnings with and without depreciation and amortization charges.

With a debt to EBITDA ratio of 1.7, Simply Good Foods uses debt wisely but responsibly. And the attractive interest coverage (EBIT of 7.7 times interest expense) certainly makes not do everything to dispel this impression. On top of that, we are pleased to report that Simply Good Foods increased its EBIT by 39%, reducing the specter of future debt repayments. When analyzing debt levels, the balance sheet is the obvious starting point. But future earnings, more than anything, will determine Simply Good Foods’ ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.

Finally, while the taxman may love accounting profits, lenders only accept cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Simply Good Foods has recorded free cash flow of 56% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This cold hard cash allows him to reduce his debt whenever he wants.

Our point of view

Simply Good Foods’ EBIT growth rate suggests it can manage its debt as easily as Cristiano Ronaldo could score a goal against an Under-14 goalkeeper. And its interest coverage is good too. Given all of this data, it seems to us that Simply Good Foods is taking a pretty sensible approach to debt. This means they take on a bit more risk, hoping to increase shareholder returns. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. For example, we found 2 warning signs for Simply Good Foods which you should be aware of before investing here.

If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.

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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.