Churchill Downs (NASDAQ:CHDN) Takes On Some Risk With Its Use Of Debt

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 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. Importantly, Churchill Downs Incorporated (NASDAQ:CHDN) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Churchill Downs

What Is Churchill Downs's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2023 Churchill Downs had US$4.72b of debt, an increase on US$3.18b, over one year. However, it does have US$129.9m in cash offsetting this, leading to net debt of about US$4.59b.

A Look At Churchill Downs' Liabilities

The latest balance sheet data shows that Churchill Downs had liabilities of US$669.9m due within a year, and liabilities of US$5.19b falling due after that. Offsetting this, it had US$129.9m in cash and US$108.1m in receivables that were due within 12 months. So its liabilities total US$5.62b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Churchill Downs is worth US$9.48b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 6.5 hit our confidence in Churchill Downs like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. The good news is that Churchill Downs grew its EBIT a smooth 54% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Churchill Downs can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Churchill Downs recorded free cash flow of 25% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Churchill Downs's ability handle its debt, based on its EBITDA, nor its interest cover gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Churchill Downs is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Churchill Downs is showing 2 warning signs in our investment analysis , and 1 of those is significant...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.