Howard Marks put it well when he said, rather than worry about the volatility of the share price, ‘The possibility of permanent loss is the risk I worry about… and every active investor I know worries about.’ When we think about how risky a company is, we always like to look at its debt utilization, because an overload of debt can lead to bankruptcy. Importantly, PENN Entertainment, Inc. (NASDAQ: PENN) carries debt. But does this debt concern shareholders?
Why Does Debt Bring Risk?
Debt and liabilities become a risk to a business when it cannot easily meet those obligations, either through free cash flow or by raising capital at an attractive rate. If things get too bad, creditors can take control of the business. However, a common (but still painful) situation is that new equity capital must be raised at a low cost, thereby permanently depleting shareholders. By changing dilution, however, debt can be an excellent tool for businesses that need capital to invest in growth with high rates of return. When we think about how a company uses debt, we first look at cash and debt together.
See i opportunities and risks within the US Hospitality industry.
What is PENN Entertainment’s debt?
The chart below, which you can click on for more details, shows that as of June 2022 PENN Entertainment had US$2.79b in debt, up from US$2.36b in one year. However, because it has cash reserves of US$1.71b, its debt is lower, at about US$1.08b.
A Look at PENN Entertainment’s Liabilities
The latest balance sheet data shows that PENN Entertainment has US$1.09b of debt due within a year, with US$13.0b of debt falling due after that. On the other hand, it had US$1.71b in cash and US$169.4m worth of earnings during the year. It therefore has liabilities amounting to US$12.2b more than its cash and short-term receivables, combined.
This deficit casts a shadow over the US$4.93b company, like a colossus towering above mortals. So we will watch the balance sheet closely, no doubt. After all, PENN Entertainment may need to refinance if it has to pay its creditors today.
We use two key ratios to inform debt-to-income levels. The first is the remaining debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how much of its earnings before interest and tax (EBIT) covers the cost of interest (or its interest, for short) . In this way, we consider both the amount of the loan, and the interest paid on it.
Given that total debt is only 0.69 times EBITDA, it is first surprising to see that PENN Entertainment’s EBIT has a low interest rate of 1.7 times. So while we are not surprised we think that its case is very far. If PENN Entertainment can continue to grow its EBIT at the annual rate of 19% last year, then it will find its debt load easier to manage. When analyzing debt levels, the balance sheet is an obvious place to start. But it’s future earnings, more than anything else, that will determine PENN Entertainment’s ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check this out for free a report showing an analyst’s earnings estimate.
Finally, while the taxman may like income from accounting, lenders only accept cold hard cash. So we need to clearly see if that EBIT leads to free cash flow. Over the last three years, PENN Entertainment recorded free cash flow of 61% of its EBIT, which is around the norm, given free cash flow excludes interest and taxes. This cold hard cash means it can reduce its debt if it wants to.
Both PENN’s level of interest in total debt and interest coverage were disappointing. But on the bright side of life, their debt to EBITDA leaves us feeling even better. Taking the aforementioned factors together we think that PENN Entertainment’s case poses some risks to the business. While that debt could increase returns, we think the company has enough volume right now. When analyzing debt levels, the balance sheet is an obvious place to start. But ultimately, every company can contain risks that exist off the balance sheet. We identified 2 warning signs by PENN Entertainment, and their insights should be part of your investment process.
At the end of the day, it’s often better to focus on companies that don’t have debt. You can access our exclusive list of such companies (all with a track record of revenue growth). It’s free.
Valuation is complicated, but we help make it easy.
Find out if PENN Entertainment It may or may not be worth it based on our extensive, inclusive analysis fair value estimation, risks and caveats, dividends, insider trading and financial health.
See Free Analysis
Do you have an answer to this article? Worried about content? Hook up directly with us. Alternatively, email edit-team(at)easywallst.com.
This article by Simply Wall St is casual in nature. We provide commentary based on historical data and analyst estimates only using an unbiased approach and our articles are not intended to be financial advice. It does not make a recommendation to buy or sell any stock, and does not take into account your goals, or your financial situation. We aim to bring you focused long-term analysis driven by fundamental data. Note that our analysis may not include company announcements that look at recent price or quality materials. Simple Wall St has no position in any of the stocks mentioned.