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.' 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 SMART Global Holdings, Inc. (NASDAQ:SGH) 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?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for SMART Global Holdings

What Is SMART Global Holdings's Net Debt?

The image below, which you can click on for greater detail, shows that at May 2023 SMART Global Holdings had debt of US$814.5m, up from US$493.8m in one year. However, because it has a cash reserve of US$401.3m, its net debt is less, at about US$413.2m.

A Look At SMART Global Holdings' Liabilities

According to the last reported balance sheet, SMART Global Holdings had liabilities of US$384.3m due within 12 months, and liabilities of US$882.7m due beyond 12 months. On the other hand, it had cash of US$401.3m and US$263.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$602.4m.

While this might seem like a lot, it is not so bad since SMART Global Holdings has a market capitalization of US$1.22b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

SMART Global Holdings has a debt to EBITDA ratio of 2.7 and its EBIT covered its interest expense 2.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Worse, SMART Global Holdings's EBIT was down 59% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if SMART Global Holdings 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, SMART Global Holdings recorded free cash flow worth 64% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

We'd go so far as to say SMART Global Holdings's EBIT growth rate was disappointing. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that SMART Global Holdings's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with SMART Global Holdings (at least 1 which doesn't sit too well with us) , and understanding them should be part of your investment process.

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.