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. 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 Noodles & Company (NASDAQ:NDLS) does use debt in its business. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. 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.
How Much Debt Does Noodles Carry?
You can click the graphic below for the historical numbers, but it shows that Noodles had US$43.1m of debt in October 2019, down from US$47.8m, one year before. However, it does have US$3.09m in cash offsetting this, leading to net debt of about US$40.0m.
A Look At Noodles's Liabilities
Zooming in on the latest balance sheet data, we can see that Noodles had liabilities of US$51.0m due within 12 months and liabilities of US$275.6m due beyond that. Offsetting these obligations, it had cash of US$3.09m as well as receivables valued at US$2.47m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$321.0m.
Given this deficit is actually higher than the company's market capitalization of US$274.4m, we think shareholders really should watch Noodles's debt levels, like a parent watching their child ride a bike for the first time. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Noodles has a very low debt to EBITDA ratio of 1.3 so it is strange to see weak interest coverage, with last year's EBIT being only 2.4 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. One way Noodles could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 12%, as it did over the last year. 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 Noodles 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last two years, Noodles created free cash flow amounting to 8.3% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
To be frank both Noodles's level of total liabilities and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Noodles's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Noodles's earnings per share history for free.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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