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 Shake Shack Inc. (NYSE:SHAK) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.

What Is Shake Shack’s Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Shake Shack had US$243.0m of debt, an increase on none, over one year. But it also has US$420.2m in cash to offset that, meaning it has US$177.2m net cash.

How Healthy Is Shake Shack’s Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Shake Shack had liabilities of US$124.5m due within 12 months and liabilities of US$864.2m due beyond that. Offsetting this, it had US$420.2m in cash and US$11.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$556.8m.

Since publicly traded Shake Shack shares are worth a total of US$2.97b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Despite its noteworthy liabilities, Shake Shack boasts net cash, so it’s fair to say it does not have a heavy debt load! When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Shake Shack can strengthen its balance sheet over time.

Over 12 months, Shake Shack reported revenue of US$631m, which is a gain of 16%, although it did not report any earnings before interest and tax. We usually like to see faster growth from unprofitable companies, but each to their own.

So How Risky Is Shake Shack?

We have no doubt that loss making companies are, in general, riskier than profitable ones. And in the last year Shake Shack had an earnings before interest and tax (EBIT) loss, truth be told. And over the same period it saw negative free cash outflow of US$20m and booked a US$22m accounting loss. With only US$177.2m on the balance sheet, it would appear that its going to need to raise capital again soon. Overall, we’d say the stock is a bit risky, and we’re usually very cautious until we see positive free cash flow. When analysing debt levels, the balance sheet is the obvious place to start.