We Think Topgolf Callaway Brands (NYSE:MODG) Is Taking Some Risk With Its Debt

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 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 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?

Why Does Debt Bring Risk?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

View our latest analysis for Topgolf Callaway Brands

What Is Topgolf Callaway Brands's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2022 Topgolf Callaway Brands had debt of US$1.41b, up from US$1.06b in one year. On the flip side, it has US$184.6m in cash leading to net debt of about US$1.22b.

How Healthy Is Topgolf Callaway Brands' Balance Sheet?

The latest balance sheet data shows that Topgolf Callaway Brands had liabilities of US$1.18b due within a year, and liabilities of US$3.64b falling due after that. Offsetting these obligations, it had cash of US$184.6m as well as receivables valued at US$242.1m due within 12 months. So its liabilities total US$4.39b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of US$3.92b, we think shareholders really should watch Topgolf Callaway Brands'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.

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.

While Topgolf Callaway Brands's debt to EBITDA ratio (2.6) suggests that it uses some debt, its interest cover is very weak, at 1.9, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. On the other hand, Topgolf Callaway Brands grew its EBIT by 29% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Topgolf Callaway Brands's ability to maintain a healthy balance sheet going forward. 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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Topgolf Callaway Brands burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Topgolf Callaway Brands's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Topgolf Callaway Brands's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For example - Topgolf Callaway Brands 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.

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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.