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. Importantly, Golden Entertainment, Inc. (NASDAQ:GDEN) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.
What Is Golden Entertainment's Net Debt?
The image below, which you can click on for greater detail, shows that Golden Entertainment had debt of US$1.13b at the end of March 2021, a reduction from US$1.33b over a year. On the flip side, it has US$145.4m in cash leading to net debt of about US$982.7m.
How Strong Is Golden Entertainment's Balance Sheet?
The latest balance sheet data shows that Golden Entertainment had liabilities of US$141.9m due within a year, and liabilities of US$1.30b falling due after that. On the other hand, it had cash of US$145.4m and US$15.1m worth of receivables due within a year. So it has liabilities totalling US$1.28b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's US$1.24b market capitalization, you might well be inclined to review the balance sheet intently. 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 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).
Weak interest cover of 0.021 times and a disturbingly high net debt to EBITDA ratio of 8.1 hit our confidence in Golden Entertainment like a one-two punch to the gut. The debt burden here is substantial. Even worse, Golden Entertainment saw its EBIT tank 96% 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. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Golden Entertainment'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Golden Entertainment recorded free cash flow worth 72% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
To be frank both Golden Entertainment's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We're quite clear that we consider Golden Entertainment to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Golden Entertainment is showing 2 warning signs in our investment analysis , you should know about...
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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