Here's Why Cheesecake Factory (NASDAQ:CAKE) Can Manage Its Debt Responsibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 The Cheesecake Factory Incorporated (NASDAQ:CAKE) does use debt in its business. But the real question is whether this debt is making the company risky.

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

See our latest analysis for Cheesecake Factory

What Is Cheesecake Factory's Net Debt?

As you can see below, at the end of December 2021, Cheesecake Factory had US$466.0m of debt, up from US$280.0m a year ago. Click the image for more detail. However, it does have US$189.6m in cash offsetting this, leading to net debt of about US$276.4m.

How Healthy Is Cheesecake Factory's Balance Sheet?

We can see from the most recent balance sheet that Cheesecake Factory had liabilities of US$636.3m falling due within a year, and liabilities of US$1.83b due beyond that. Offsetting these obligations, it had cash of US$189.6m as well as receivables valued at US$136.7m due within 12 months. So it has liabilities totalling US$2.14b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of US$2.02b, we think shareholders really should watch Cheesecake Factory's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Cheesecake Factory's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 11.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. It was also good to see that despite losing money on the EBIT line last year, Cheesecake Factory turned things around in the last 12 months, delivering and EBIT of US$125m. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Happily for any shareholders, Cheesecake Factory actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Both Cheesecake Factory's ability to to convert EBIT to free cash flow and its interest cover gave us comfort that it can handle its debt. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Cheesecake Factory has 3 warning signs we think 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.