David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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, Brookdale Senior Living Inc. (NYSE:BKD) does carry debt. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Brookdale Senior Living’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Brookdale Senior Living had US$2.96b of debt in December 2019, down from US$3.64b, one year before. On the flip side, it has US$308.8m in cash leading to net debt of about US$2.66b.
How Strong Is Brookdale Senior Living’s Balance Sheet?
According to the last reported balance sheet, Brookdale Senior Living had liabilities of US$1.05b due within 12 months, and liabilities of US$5.45b due beyond 12 months. Offsetting these obligations, it had cash of US$308.8m as well as receivables valued at US$133.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$6.05b.
This deficit casts a shadow over the US$1.55b company, like a colossus towering over mere mortals. So we’d watch its balance sheet closely, without a doubt. At the end of the day, Brookdale Senior Living would probably need a major re-capitalization if its creditors were to demand repayment.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Brookdale Senior Living shareholders face the double whammy of a high net debt to EBITDA ratio (6.8), and fairly weak interest coverage, since EBIT is just 0.034 times the interest expense. The debt burden here is substantial. Even worse, Brookdale Senior Living saw its EBIT tank 91% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Brookdale Senior Living’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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. 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, Brookdale Senior Living burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
To be frank both Brookdale Senior Living’s EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. It’s also worth noting that Brookdale Senior Living is in the Healthcare industry, which is often considered to be quite defensive. It looks to us like Brookdale Senior Living carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we’d probably give this stock a wide berth. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example – Brookdale Senior Living has 1 warning sign we think you should be aware of.
At the end of the day, it’s often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It’s free.
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.
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