Howard Marks said it well when he said that, rather than worrying about share price volatility, ‘The risk of losing outright is the risk I worry about… and every active trader I know worries about.’ When we think about how risky a company is, we always want to look at its debt usage, since too much debt can lead to bankruptcy. Main course, History of PENN Entertainment, Inc. (NASDAQ: PENN) carries debt. But does this debt matter to the shareholders?
Why Is Credit Risky?
Debt and other liabilities become dangerous for a business if it cannot meet its obligations easily, either by free cash flow or by raising capital at an attractive price. When things get really bad, creditors can take control of the business. However, one common (but still painful) situation is that it has to raise new equity capital at a low cost, thereby completely alienating shareholders. By replacing dilution, however, debt can be a very good tool for businesses that need capital to invest in growth with high rates of return. When we consider a company’s use of debt, we first look at cash and debt together.
Look outside opportunities and risks within the US Hospitality industry.
What is PENN Entertainment’s Credit?
The figure below, which you can click on for more information, shows that in June 2022 PENN Entertainment had US$2.79b in debt, up from US$2.36b in one year. However, because it has a reserve of US$1.71b, its debt is less, to US$1.08b.
Focus on PENN Entertainment loans
The latest balance sheet data shows that PENN Entertainment had US$1.09b in loans due during the year, with US$13.0b in loans falling after that. On the other hand, it had revenue of US$1.71b and US$169.4m worth of revenue during the year. So it has liabilities of US$12.2b more than its capital and near-term earnings, combined.
This deficiency casts a shadow over the US$4.93b company, like a colossus that surpasses ordinary people. So we looked at its balance sheet, without a doubt. After all, PENN Entertainment would probably need a big refund if it had to pay off creditors today.
We use two major ratios to inform us of the level of debt relative to income. The first is net debt divided by earnings before interest, taxes, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and taxes (EBIT) cover its interest expense (or its interest cover, for short). In this way, we consider both the total amount of the loan, as well as the interest rates paid on it.
Given that total debt is only 0.69 times EBITDA, it is surprising to see that PENN Entertainment’s EBIT has a low interest rate of 1.7 times. So although we are not panicking we think that its debt is far from easy. If PENN Entertainment can continue to grow EBIT at last year’s rate of 19% over the previous year, then it will find its debt burden easier to handle. When analyzing debt levels, the balance sheet is the obvious place to start. But future earnings, more than anything else, will prove PENN Entertainment’s ability to maintain a healthy balance sheet going forward. So if you are looking to the future you can look at this they are free report shows analyst profit forecasts.
Finally, while the tax-man may be interested in accounting profits, creditors only receive cold hard cash. So we need to check that this EBIT is leading to a corresponding free cash flow. Over the past three years, PENN Entertainment has recorded free cash flow worth 61% of its EBIT, which is around normal, given free cash flow excluding interest and taxes. This cold hard cash means that it can reduce its debt when needed.
Both PENN Entertainment’s level of total liabilities and its interest cover were disappointing. But on the bright side of life, its debt to EBITDA leaves us feeling happy. Taking the factors mentioned above together we think that PENN Entertainment’s debt poses some risks to the business. Although this debt can increase the return, we think that the company has enough power now. When analyzing debt levels, the balance sheet is the obvious place to start. But in the end, every company can have risks that exist outside of the bar. We have seen two warning signs and PENN Entertainment, and understanding them should be part of your investment.
At the end of the day, it’s often better to look at companies that don’t have loans. You can find our special list of such companies (all with a track record of profit growth). It is not paid.
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This Simply Wall St article is casual in nature. We provide commentary based on historical data and analysts’ estimates only using an unbiased approach and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and it does not take into account your goals, or your financial situation. We aim to bring you long-term focused research driven by valuable data. Note that our analysis may not result in price-sensitive or quality-sensitive company advertisements. Simply Wall St has no position in any of the stocks mentioned.