Penn National Gaming (NASDAQ:PENN) Has A Somewhat Strained Balance Sheet

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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Penn National Gaming, Inc. (NASDAQ:PENN) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 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 Penn National Gaming

What Is Penn National Gaming's Debt?

As you can see below, at the end of December 2021, Penn National Gaming had US$2.74b of debt, up from US$2.31b a year ago. Click the image for more detail. On the flip side, it has US$1.86b in cash leading to net debt of about US$872.9m.

How Healthy Is Penn National Gaming's Balance Sheet?

According to the last reported balance sheet, Penn National Gaming had liabilities of US$1.13b due within 12 months, and liabilities of US$11.6b due beyond 12 months. Offsetting this, it had US$1.86b in cash and US$182.2m in receivables that were due within 12 months. So it has liabilities totalling US$10.7b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the US$6.98b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Penn National Gaming would probably need a major re-capitalization if its creditors were to demand repayment.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Given net debt is only 0.60 times EBITDA, it is initially surprising to see that Penn National Gaming's EBIT has low interest coverage of 2.0 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Notably, Penn National Gaming's EBIT launched higher than Elon Musk, gaining a whopping 391% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Penn National Gaming'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Penn National Gaming produced sturdy free cash flow equating to 64% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Penn National Gaming's level of total liabilities and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Penn National Gaming is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Penn National Gaming that 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.