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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies The Cheesecake Factory Incorporated (NASDAQ:CAKE) makes use of debt. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Cheesecake Factory's Debt?

As you can see below, Cheesecake Factory had US$470.0m of debt, at January 2024, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$56.3m in cash leading to net debt of about US$413.8m.

A Look At Cheesecake Factory's Liabilities

We can see from the most recent balance sheet that Cheesecake Factory had liabilities of US$660.7m falling due within a year, and liabilities of US$1.86b due beyond that. Offsetting this, it had US$56.3m in cash and US$123.8m in receivables that were due within 12 months. So its liabilities total US$2.34b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of US$1.76b, we think shareholders really should watch Cheesecake Factory's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

We'd say that Cheesecake Factory's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its strong interest cover of 17.5 times, makes us even more comfortable. It is well worth noting that Cheesecake Factory's EBIT shot up like bamboo after rain, gaining 79% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Cheesecake Factory'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Cheesecake Factory produced sturdy free cash flow equating to 73% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Both Cheesecake Factory's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. Considering this range of data points, we think Cheesecake Factory is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For example, we've discovered 3 warning signs for Cheesecake Factory that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.