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. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Del Taco Restaurants, Inc. (NASDAQ:TACO) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Del Taco Restaurants's Net Debt?
As you can see below, Del Taco Restaurants had US$146.1m of debt at June 2019, down from US$171.5m a year prior. On the flip side, it has US$5.25m in cash leading to net debt of about US$140.8m.
How Healthy Is Del Taco Restaurants's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Del Taco Restaurants had liabilities of US$75.1m due within 12 months and liabilities of US$457.0m due beyond that. Offsetting these obligations, it had cash of US$5.25m as well as receivables valued at US$2.27m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$524.5m.
When you consider that this deficiency exceeds the company's US$366.3m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Del Taco Restaurants's net debt is sitting at a very reasonable 2.3 times its EBITDA, while its EBIT covered its interest expense just 4.3 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Sadly, Del Taco Restaurants's EBIT actually dropped 5.2% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Del Taco Restaurants 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Del Taco Restaurants's free cash flow amounted to 28% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
We'd go so far as to say Del Taco Restaurants's level of total liabilities was disappointing. But at least its net debt to EBITDA is not so bad. We're quite clear that we consider Del Taco Restaurants to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Given our hesitation about the stock, it would be good to know if Del Taco Restaurants insiders have sold any shares recently. You click here to find out if insiders have sold recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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