Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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. We note that Carrols Restaurant Group, Inc. (NASDAQ:TAST) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we think about a company’s use of debt, we first look at cash and debt together.

How Much Debt Does Carrols Restaurant Group Carry?

As you can see below, Carrols Restaurant Group had US$481.5m of debt at April 2021, down from US$529.5m a year prior. However, it does have US$59.9m in cash offsetting this, leading to net debt of about US$421.6m.

A Look At Carrols Restaurant Group’s Liabilities

We can see from the most recent balance sheet that Carrols Restaurant Group had liabilities of US$158.8m falling due within a year, and liabilities of US$1.32b due beyond that. Offsetting these obligations, it had cash of US$59.9m as well as receivables valued at US$19.7m due within 12 months. So its liabilities total US$1.40b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the US$291.4m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Carrols Restaurant Group would probably need a major re-capitalization if its creditors were to demand repayment.

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.

While we wouldn’t worry about Carrols Restaurant Group’s net debt to EBITDA ratio of 3.8, we think its super-low interest cover of 1.1 times is a sign of high leverage. In large part that’s due to the company’s significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. One redeeming factor for Carrols Restaurant Group is that it turned last year’s EBIT loss into a gain of US$29m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Carrols Restaurant Group can strengthen its balance sheet over time.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Carrols Restaurant Group actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On the face of it, Carrols Restaurant Group’s interest cover left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Overall, we think it’s fair to say that Carrols Restaurant Group has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet – far from it. These risks can be hard to spot.