Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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. As with many other companies The Cheesecake Factory Incorporated (NASDAQ:CAKE) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
Check out our latest analysis for Cheesecake Factory
How Much Debt Does Cheesecake Factory Carry?
You can click the graphic below for the historical numbers, but it shows that as of September 2021 Cheesecake Factory had US$465.5m of debt, an increase on US$376.0m, over one year. However, it also had US$131.0m in cash, and so its net debt is US$334.5m.
How Strong Is Cheesecake Factory’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Cheesecake Factory had liabilities of US$557.1m due within 12 months and liabilities of US$1.84b due beyond that. Offsetting this, it had US$131.0m in cash and US$106.2m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$2.16b.
Given this deficit is actually higher than the company’s market capitalization of US$2.10b, we think shareholders really should watch Cheesecake Factory’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.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a debt to EBITDA ratio of 1.8, Cheesecake Factory uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 8.7 times its interest expenses harmonizes with that theme. We also note that Cheesecake Factory improved its EBIT from a last year’s loss to a positive US$94m. 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 Cheesecake Factory 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 it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Cheesecake Factory recorded free cash flow worth a fulsome 99% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
Our View
When it comes to the balance sheet, the standout positive for Cheesecake Factory was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren’t so encouraging. For instance it seems like it has to struggle a bit to handle its total liabilities. When we consider all the factors mentioned above, we do feel a bit cautious about Cheesecake Factory’s use of debt. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. For instance, we’ve identified 3 warning signs for Cheesecake Factory that you should be aware of.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
