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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. 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. Importantly, Golden Entertainment, Inc. (NASDAQ:GDEN) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does Golden Entertainment Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Golden Entertainment had US$1.12b of debt, an increase on US$970.4m, over one year. On the flip side, it has US$116.7m in cash leading to net debt of about US$1.00b.
A Look At Golden Entertainment's Liabilities
Zooming in on the latest balance sheet data, we can see that Golden Entertainment had liabilities of US$122.8m due within 12 months and liabilities of US$1.27b due beyond that. Offsetting these obligations, it had cash of US$116.7m as well as receivables valued at US$15.3m due within 12 months. So it has liabilities totalling US$1.26b more than its cash and near-term receivables, combined.
This deficit casts a shadow over the US$359.2m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Golden Entertainment would likely require a major re-capitalisation if it had to pay its creditors today.
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.
Weak interest cover of 0.70 times and a disturbingly high net debt to EBITDA ratio of 6.5 hit our confidence in Golden Entertainment like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Fortunately, Golden Entertainment grew its EBIT by 2.4% in the last year, slowly shrinking its debt relative to earnings. 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 Golden Entertainment 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Golden Entertainment recorded free cash flow of 30% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
On the face of it, Golden Entertainment's interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. Taking into account all the aforementioned factors, it looks like Golden Entertainment has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. Given the risks around Golden Entertainment's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
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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