The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Brookdale Senior Living Inc. (NYSE:BKD) does carry debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

What Is Brookdale Senior Living's Debt?

The chart below, which you can click on for greater detail, shows that Brookdale Senior Living had US$3.76b in debt in March 2024; about the same as the year before. However, it does have US$318.5m in cash offsetting this, leading to net debt of about US$3.44b.

How Strong Is Brookdale Senior Living's Balance Sheet?

The latest balance sheet data shows that Brookdale Senior Living had liabilities of US$614.3m due within a year, and liabilities of US$4.55b falling due after that. Offsetting this, it had US$318.5m in cash and US$49.6m in receivables that were due within 12 months. So its liabilities total US$4.80b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the US$1.26b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Brookdale Senior Living would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Brookdale Senior Living shareholders face the double whammy of a high net debt to EBITDA ratio (9.0), and fairly weak interest coverage, since EBIT is just 0.18 times the interest expense. This means we'd consider it to have a heavy debt load. One redeeming factor for Brookdale Senior Living is that it turned last year's EBIT loss into a gain of US$39m, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Brookdale Senior Living can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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, Brookdale Senior Living saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Brookdale Senior Living's conversion of EBIT to free cash flow 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 its EBIT growth rate is not so bad. It's also worth noting that Brookdale Senior Living is in the Healthcare industry, which is often considered to be quite defensive. Taking into account all the aforementioned factors, it looks like Brookdale Senior Living has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. Every company has them, and we've spotted 2 warning signs for Brookdale Senior Living you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com