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We Think Restaurant Group (LON:RTN) Is Taking Some Risk With Its 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. Importantly, The Restaurant Group plc (LON:RTN) does carry debt. But is this debt a concern to shareholders?

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, 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.

Check out our latest analysis for Restaurant Group

How Much Debt Does Restaurant Group Carry?

As you can see below, at the end of June 2019, Restaurant Group had UK£343.5m of debt, up from UK£32.0m a year ago. Click the image for more detail. On the flip side, it has UK£31.9m in cash leading to net debt of about UK£311.6m.

LSE:RTN Historical Debt, October 14th 2019

How Healthy Is Restaurant Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Restaurant Group had liabilities of UK£189.0m due within 12 months and liabilities of UK£477.3m due beyond that. On the other hand, it had cash of UK£31.9m and UK£20.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£613.7m.

This deficit is considerable relative to its market capitalization of UK£711.7m, so it does suggest shareholders should keep an eye on Restaurant Group's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Restaurant Group has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 6.8 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We note that Restaurant Group grew its EBIT by 30% in the last year, and that should make it easier to pay down debt, going forward. 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 Restaurant Group 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Restaurant Group recorded free cash flow of 24% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Restaurant Group's ability to handle its total liabilities nor its conversion of EBIT to free cash flow gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Restaurant Group is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.

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 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.