Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We note that Darden Restaurants, Inc. (NYSE:DRI) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Darden Restaurants’s Net Debt?
The chart below, which you can click on for greater detail, shows that Darden Restaurants had US$930.3m in debt in May 2023; about the same as the year before. However, it also had US$367.8m in cash, and so its net debt is US$562.5m.
How Strong Is Darden Restaurants’ Balance Sheet?
According to the last reported balance sheet, Darden Restaurants had liabilities of US$1.94b due within 12 months, and liabilities of US$6.10b due beyond 12 months. Offsetting this, it had US$367.8m in cash and US$72.9m in receivables that were due within 12 months. So it has liabilities totalling US$7.60b more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Darden Restaurants is worth a massive US$19.7b, 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.
Darden Restaurants has a low net debt to EBITDA ratio of only 0.36. And its EBIT easily covers its interest expense, being 14.7 times the size. So we’re pretty relaxed about its super-conservative use of debt. Fortunately, Darden Restaurants grew its EBIT by 2.7% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Darden Restaurants’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 it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Darden Restaurants recorded free cash flow worth a fulsome 91% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
The good news is that Darden Restaurants’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Taking all this data into account, it seems to us that Darden Restaurants takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example – Darden Restaurants has 2 warning signs we think you should be aware of.
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.
What are the risks and opportunities for Darden Restaurants?
Price-To-Earnings ratio (20x) is below the Hospitality industry average (21.6x)
Earnings are forecast to grow 7.01% per year
Earnings grew by 2.9% over the past year
Significant insider selling over the past 3 months
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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.