Topgolf Callaway Brands (NYSE:MODG) Use Of Debt Could Be Considered Risky

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 Topgolf Callaway Brands Corp. (NYSE:MODG) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Topgolf Callaway Brands

What Is Topgolf Callaway Brands's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Topgolf Callaway Brands had US$1.52b of debt in September 2024, down from US$1.62b, one year before. However, because it has a cash reserve of US$443.7m, its net debt is less, at about US$1.08b.

A Look At Topgolf Callaway Brands' Liabilities

The latest balance sheet data shows that Topgolf Callaway Brands had liabilities of US$842.5m due within a year, and liabilities of US$4.38b falling due after that. On the other hand, it had cash of US$443.7m and US$389.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$4.39b.

This deficit casts a shadow over the US$1.48b 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, Topgolf Callaway Brands 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Even though Topgolf Callaway Brands's debt is only 2.4, its interest cover is really very low at 0.82. In large part that's it has so much depreciation and amortisation. While companies often boast that these charges are non-cash, most such businesses will therefore require ongoing investment (that is not expensed.) In any case, it's safe to say the company has meaningful debt. Shareholders should be aware that Topgolf Callaway Brands's EBIT was down 22% 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. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Topgolf Callaway Brands 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Topgolf Callaway Brands saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Topgolf Callaway Brands's EBIT growth rate left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its net debt to EBITDA is not so bad. It looks to us like Topgolf Callaway Brands 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. While Topgolf Callaway Brands didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.

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.