Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that El Pollo Loco Holdings, Inc. (NASDAQ:LOCO) does use debt in its business. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is El Pollo Loco Holdings's Net Debt?
As you can see below, El Pollo Loco Holdings had US$71.2m of debt at March 2019, down from US$85.3m a year prior. However, it also had US$6.70m in cash, and so its net debt is US$64.5m.
How Strong Is El Pollo Loco Holdings's Balance Sheet?
We can see from the most recent balance sheet that El Pollo Loco Holdings had liabilities of US$98.6m falling due within a year, and liabilities of US$284.9m due beyond that. Offsetting this, it had US$6.70m in cash and US$10.8m in receivables that were due within 12 months. So it has liabilities totalling US$366.0m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of US$391.6m. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
El Pollo Loco Holdings's net debt is only 1.1 times its EBITDA. And its EBIT covers its interest expense a whopping 11.7 times over. So we're pretty relaxed about its super-conservative use of debt. On the other hand, El Pollo Loco Holdings saw its EBIT drop by 5.3% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if El Pollo Loco Holdings 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, El Pollo Loco Holdings's free cash flow amounted to 37% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
El Pollo Loco Holdings's level of total liabilities and EBIT growth rate definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think El Pollo Loco Holdings's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. While El Pollo Loco Holdings didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away.Click here to see if its earnings are heading in the right direction, over the medium term.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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