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. We note that The Cheesecake Factory Incorporated (NASDAQ:CAKE) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Cheesecake Factory Carry?
You can click the graphic below for the historical numbers, but it shows that Cheesecake Factory had US$35.0m of debt in July 2019, down from US$134.8m, one year before. However, because it has a cash reserve of US$22.6m, its net debt is less, at about US$12.4m.
How Healthy Is Cheesecake Factory's Balance Sheet?
According to the last reported balance sheet, Cheesecake Factory had liabilities of US$437.0m due within 12 months, and liabilities of US$1.10b due beyond 12 months. On the other hand, it had cash of US$22.6m and US$50.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.46b.
This is a mountain of leverage relative to its market capitalization of US$1.77b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Carrying virtually no net debt, Cheesecake Factory has a very light debt load indeed.
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.
Cheesecake Factory has very little debt (net of cash), and boasts a debt to EBITDA ratio of 0.054 and EBIT of 40.3 times the interest expense. Indeed relative to its earnings its debt load seems light as a feather. While Cheesecake Factory doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Cheesecake Factory's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Cheesecake Factory recorded free cash flow worth a fulsome 94% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Happily, Cheesecake Factory's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. Looking at all the aforementioned factors together, it strikes us that Cheesecake Factory can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. We'd be motivated to research the stock further if we found out that Cheesecake Factory insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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 firstname.lastname@example.org. 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.