Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. As with many other companies John B. Sanfilippo & Son, Inc. (NASDAQ:JBSS) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. When we think about a company’s use of debt, we first look at cash and debt together.

How Much Debt Does John B. Sanfilippo & Son Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2021 John B. Sanfilippo & Son had US$59.2m of debt, an increase on US$53.0m, over one year. And it doesn’t have much cash, so its net debt is about the same.

How Healthy Is John B. Sanfilippo & Son’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that John B. Sanfilippo & Son had liabilities of US$123.8m due within 12 months and liabilities of US$55.2m due beyond that. Offsetting this, it had US$539.0k in cash and US$71.9m in receivables that were due within 12 months. So its liabilities total US$106.5m more than the combination of its cash and short-term receivables.

Given John B. Sanfilippo & Son has a market capitalization of US$1.04b, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

John B. Sanfilippo & Son’s net debt is only 0.57 times its EBITDA. And its EBIT covers its interest expense a whopping 62.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also good is that John B. Sanfilippo & Son grew its EBIT at 14% over the last year, further increasing its ability to manage debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine John B. Sanfilippo & Son’s ability to maintain a healthy balance sheet going forward.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, John B. Sanfilippo & Son generated free cash flow amounting to a very robust 81% of its EBIT, more than we’d expect. That puts it in a very strong position to pay down debt.

Our View

Happily, John B. Sanfilippo & Son’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Overall, we don’t think John B. Sanfilippo & Son is taking any bad risks, as its debt load seems modest. So we’re not worried about the use of a little leverage on the balance sheet. There’s no doubt that we learn most about debt from the balance sheet.