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. 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 can see that Cracker Barrel Old Country Store, Inc. (NASDAQ:CBRL) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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. 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.
What Is Cracker Barrel Old Country Store’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of May 2020 Cracker Barrel Old Country Store had US$966.7m of debt, an increase on US$401.7m, over one year. However, because it has a cash reserve of US$363.3m, its net debt is less, at about US$603.4m.
How Healthy Is Cracker Barrel Old Country Store’s Balance Sheet?
According to the last reported balance sheet, Cracker Barrel Old Country Store had liabilities of US$353.4m due within 12 months, and liabilities of US$1.49b due beyond 12 months. On the other hand, it had cash of US$363.3m and US$20.6m worth of receivables due within a year. So its liabilities total US$1.46b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Cracker Barrel Old Country Store is worth US$2.59b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Cracker Barrel Old Country Store’s net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its strong interest cover of 10.2 times, makes us even more comfortable. Shareholders should be aware that Cracker Barrel Old Country Store’s EBIT was down 42% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Cracker Barrel Old Country Store can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Cracker Barrel Old Country Store produced sturdy free cash flow equating to 66% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Cracker Barrel Old Country Store’s struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its interest cover was refreshing. We think that Cracker Barrel Old Country Store’s debt does make it a bit risky, after considering the aforementioned data points together. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We’ve spotted 4 warning signs for Cracker Barrel Old Country Store you should be aware of.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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