David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Freshpet, Inc. (NASDAQ:FRPT) does use debt in its business. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

How Much Debt Does Freshpet Carry?

As you can see below, Freshpet had US$393.6m of debt, at March 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have US$257.9m in cash offsetting this, leading to net debt of about US$135.7m.

A Look At Freshpet's Liabilities

We can see from the most recent balance sheet that Freshpet had liabilities of US$81.9m falling due within a year, and liabilities of US$420.8m due beyond that. On the other hand, it had cash of US$257.9m and US$68.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$176.3m.

Of course, Freshpet has a market capitalization of US$5.78b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

We'd say that Freshpet's moderate net debt to EBITDA ratio ( being 2.2), indicates prudence when it comes to debt. And its strong interest cover of 1k times, makes us even more comfortable. We also note that Freshpet improved its EBIT from a last year's loss to a positive US$389k. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Freshpet can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. During the last year, Freshpet burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Freshpet's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its interest cover. Looking at all this data makes us feel a little cautious about Freshpet's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with Freshpet .

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com