Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We can see that Sprout Growers Market, Inc. (NASDAQ: SFM) uses debt in his business. But does this debt worry shareholders?
What risk does debt entail?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still painful) scenario is that he must raise new equity at low cost, thereby diluting shareholders over the long term. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. When we look at debt levels, we first consider both liquidity and debt levels.
How much debt does Sprouts Farmers Market have?
You can click on the graph below for historical figures, but it shows that Sprouts Farmers Market was in debt of US $ 259.8 million in April 2021, up from US $ 464.6 million a year earlier. However, because it has a cash reserve of US $ 256.0 million, its net debt is less, at approximately US $ 3.79 million.
A look at the responsibilities of Sprouts Farmers Market
According to the latest published balance sheet, Sprouts Farmers Market had a liability of US $ 490.4 million due within 12 months and a liability of US $ 1.44 billion due beyond 12 months. In return, he had $ 256.0 million in cash and $ 14.5 million in receivables due within 12 months. It therefore has liabilities totaling US $ 1.66 billion more than its cash and short-term receivables combined.
Sprouts Farmers Market has a market capitalization of US $ 3.24 billion, so it could most likely raise funds to improve its balance sheet, should the need arise. But we absolutely want to keep our eyes open for indications that its debt is too risky. With virtually no net debt, Sprouts Farmers Market has very little debt.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Sprouts Farmers Market has very little debt (net of cash) and has a debt to EBITDA ratio of 0.0075 and EBIT of 29.4 times interest expense. Indeed, compared to his income, his debt seems light as a feather. On top of that, we are happy to report that Sprouts Farmers Market has increased its EBIT by 40%, reducing the specter of future debt repayments. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the future profitability of the business will decide whether Sprouts Farmers Market can strengthen its balance sheet over time. So if you are focused on the future you can check out this free report showing analysts’ earnings forecasts.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. We must therefore clearly check whether this EBIT generates a corresponding free cash flow. Over the past three years, Sprouts Farmers Market has generated strong free cash flow equivalent to 78% of its EBIT, roughly what we expected. This hard cash allows him to reduce his debt whenever he wants.
Our point of view
Sprouts Farmers Market’s interest coverage suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 keeper. But, on a darker note, we’re a little concerned with its total liability level. When zoomed out, Sprouts Farmers Market appears to be using debt quite reasonably; and that gets the nod from us. While debt comes with risk, when used wisely, it can also generate a higher return on equity. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks lie on the balance sheet – far from it. For example, we have identified 1 warning sign for Sprouts Farmers Market of which you should be aware.
If, after all of this, you’re more interested in a fast-growing company with a rock-solid balance sheet, then check out our list of cash net growth stocks without delay.
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