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Is Good Times Restaurants (NASDAQ:GTIM) Using Too Much Debt?

Simply Wall St

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Good Times Restaurants Inc. (NASDAQ:GTIM) does use debt in its business. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

View our latest analysis for Good Times Restaurants

How Much Debt Does Good Times Restaurants Carry?

As you can see below, at the end of June 2019, Good Times Restaurants had US$11.2m of debt, up from US$5.14m a year ago. Click the image for more detail. On the flip side, it has US$2.62m in cash leading to net debt of about US$8.53m.

NasdaqCM:GTIM Historical Debt, September 11th 2019

How Strong Is Good Times Restaurants's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Good Times Restaurants had liabilities of US$7.80m due within 12 months and liabilities of US$19.4m due beyond that. Offsetting these obligations, it had cash of US$2.62m as well as receivables valued at US$366.0k due within 12 months. So its liabilities total US$24.3m more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of US$21.9m, we think shareholders really should watch Good Times Restaurants's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). 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).

Even though Good Times Restaurants's debt is only 1.7, its interest cover is really very low at 0.69. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. Either way there's no doubt the stock is using meaningful leverage. Pleasingly, Good Times Restaurants is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 106% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Good Times Restaurants can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, Good Times Restaurants saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Good Times Restaurants's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. Overall, we think it's fair to say that Good Times Restaurants has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. While Good Times Restaurants 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.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.