Casino Enterprise Management

While current operating activities are important, to remain in existence properties must be able to meet all future obligations. The final part of evaluating financial stability is to look at the
long-term prospects of casino properties. The concern is whether the property is generating enough cash to not only run current operations, but also to meet future commitments such as loans, bond payments, guarantees and capital improvements. A combination of ratios and trend analysis is used to evaluate this element of financial stability.

Traditional Solvency Ratios
For years analysts and creditors used a series of ratios for
defining the risk associated with a company. The more debt taken on, the more risk there was for the creditors. The commonly used ratios included a) debt-to-equity; b) debt-to-assets; and c) interest coverage.

• Debt-to-Equity: Total Debt / Stockholders’ Equity
The debt-to-equity ratio provides an indication of the company’s financial flexibility and risk. Debt requires fixed interest payments on specific days and eventual payment of the debt. The corporation must therefore generate enough earnings to meet these fixed interest and debt obligations. The lower this number is, the greater the financial flexibility is in terms of having options between debt and equity. When this ratio reaches 1 or higher, creditors become more reluctant to provide debt without putting on extra covenants to protect themselves. When revenues start slipping, companies can cut costs, but the only way to reduce interest payments is to pay off the debt.
• Debt-to-Assets: Total Debt / Total Assets
This ratio indicates the percentage of assets that are being financed by creditors (instead of stockholders). The general rule is that no more than 50 percent of assets should be financed by debt. Again, the higher this ratio is, the less financial flexibility the company has and the more vulnerable the property becomes to unexpected hazards and business climate changes.
• Interest Coverage: Operating Income / Interest Expense
This ratio measures the company’s ability to pay its interest charges. The higher the ratio, the better it is for the company. Notice that neither the debt-to-equity ratio nor the debt-to-assets ratio addresses the question of whether the property is generating enough cash to meet future commitments. The interest coverage ratio appears to provide an indication of meeting expectations of covering interest expenses, but not the payment of debt. The problem is that operating income is not the equivalent of cash flows.

Cash Flow Solvency
The question raised by all creditors is whether a firm has the ability to meet future interest and debt commitments on an ongoing basis. The traditional ratios derived from the income and balance-sheet statements have not been effective in providing the answer to this question. Traditional ratios used for solvency, from a trend perspective, provide evidence of potential future problems in meeting long-term commitments but do not give any clear evidence that the cash flows are available to meet these commitments. The interest coverage ratio appears to provide evidence that there are earnings to meet the interest payments. But unfortunately, earnings are based on accrual accounting and do not imply the actual generation of cash. More relevant information can be derived from the statement of cash flow.

Within the statement of cash flow, the cash flow from operations provides a much clearer picture of the capability to meet future cash commitments. A positive cash flow number provides evidence that the company has met all its current commitments and has additional cash to apply to acquire additional assets, pay off debt or pay dividends. While the statement of cash flows has been around since 1989, it has taken some time for the analyst and creditors to include this statement in their analysis. There is still no real consensus on which ratios should be used in the analysis of corporate solvency. This author believes that the following ratios provide relevant information for determining corporate solvency.

The cash flow ratios that provide an indication of meeting future cash flow commitments include: 1) free cash flow; 2) capital expenditure ratio; 3) CFO-to-debt ratio; and 4) cash flow adequacy.1

The New Jersey and Nevada gaming authorities conclude that casinos must maintain their existing properties in proper repair as part of the evaluation of financial stability. New Jersey, in fact, requires casinos to apply 5 percent of their net revenues toward capital maintenance (NJAC.19:43-4.2, Financial Stability, 1996). Thus, the question becomes whether these corporations have adequate cash flows to make these capital expenditures. The free cash flow and capital expenditure ratios would provide regulators with the answer to these questions. The other two ratios represent common ratios for evaluating long-term solvency in the credit industry.2 A description of these ratios along with their components is provided in Table 1.

   
Free Cash Flow
An increasingly popular cash flow measure is “Free Cash Flow” (FCF). FCF provides a measure of a company’s ability to meet its operational obligations. Enterprises, which do not have FCF, will need to find additional financing opportunities or require the selling off of enterprise assets to meet future commitments. This implies a lack of financial flexibility. FCFs appear in a multitude of forms as provided by analysts, creditors and annual reports.3 This measure is commonly calculated as cash flow from operations minus capital expenditures, but others argue that current debt commitments should also be subtracted to arrive at FCF. A perusal of annual reports provides extreme examples of the different uses of the term “free cash flow.” See, for example, Station Casinos, Mandalay Resort Group and Coca-Cola. Station Casinos’ FCF (1998) is defined as earnings before interest, taxes, depreciation and amortization (EBITDA) plus operating leases. Mandalay Resort Group (2000) defines FCF as the discretionary cash available after paying income taxes, interest expenses and scheduled payments of principal, and ordinary capital expenditures. Coca-Cola (1999) defines FCF as CFO less business reinvestment. In many instances, analysts and creditors still use surrogate cash flows instead of the CFO taken from the statement of cash flow.

Not only are there differences in what is included in FCF, but there can be real differences in what is included in each component. For example, there is a wide range of items included and excluded in the “capital expenditure” component. Large differences can arise between various companies due to the use of actual capital expenditures versus an estimate of the amount required to “maintain” operational assets.
 
FCF is one cash flow measure that both the Nevada and New Jersey gaming regulators have implemented as a measure of solvency. Nevada requires companies to provide actual capital maintenance figures, which they subtract from CFO (Nevada 1999). New Jersey uses CFO less 5 percent of net revenue (NJAC1996).
Since many companies do not publicly provide actual capital maintenance, this author suggests that the calculation follow the approach provided by the New Jersey gaming regulators.

Capital Expenditure Ratio
The next measure of solvency is the capital expenditure ratio. Whichever definition is used for the FCF ratio should also be incorporated in the capital expenditure ratio for consistency. The capital expenditure ratio reflects the belief that a firm’s long-term solvency is a function of (1) its ability to finance replacement and expansion of its investment in productive capacity; and (2) the amount of cash left for debt repayment after paying for capital investments. The capital expenditure ratio measures the capital available for any additional internal reinvestment. When the capital expenditure ratio exceeds 1, the company has enough funds available to meet its capital investment, with some to spare to meet debt requirements. The higher the value, the more spare cash the company has to service and repay debt.

CFO-to-Debt Ratio
CFO-to-debt provides a measure of the time frame it would take to generate enough cash to meet long-term commitments. The traditional ratio of debt-to-equity provides trend information that tells a creditor that, as more debt is taken on, there is more risk for the creditor. On the other hand, the CFO-to-debt ratio provides a better picture of whether there is enough cash being generated to actually meet those future debt commitments. This has become a very common ratio used by many credit analysts and bankers. If cash flow is decreasing compared to the debt level, this ratio would suggest future solvency problems.

Cash Flow Adequacy Ratio
The CFO-to-debt ratio looks at total debt and the capability to meet it in the future. The cash flow adequacy ratio provides a more near term of solvency. Again, different versions of this ratio are being used by various credit analysts.4 It measures the ability to meet commitments in the next five years. The ratio uses the five-year average maturity of long-term debt. This ratio reiterates the fact that a company needs to generate enough cash flow to meet future cash flow commitments such as long-term debt. If the company cannot meet its five-year cash flow needs, its going concern must begin to be questioned. By using a five-year average, the analyst is capable of looking forward and obtaining a better idea of the capabilities to meet long-term solvency.

A Solid Foundation
Whereas the common belief is that casinos are major money producers, the reality is rapid growth and greater competition have resulted in a number of firms being financially impaired; others have been forced into mergers and consolidations. As a result, many gaming jurisdictions have incorporated regulations that require continuous monitoring of casino properties to verify their financial stability and solvency. At present, there is no consensus on specific measures of financial stability and solvency, but Nevada and New Jersey gaming regulators have specific elements they have developed to assess financial stability. These states require financial information that allows analysis in three areas: 1) minimum bankroll requirements; 2) financial liquidity; and 3) financial solvency. Understanding these measurement tools could provide a solid foundation for keeping your property from being one of the financially impaired.

1    A large portion of the remainder of this article comes from a prior published  paper. Mills, J., and L. Bible, 2002, “Incorporating Cash Flow Analysis for Evaluating Casino Financial Stability,” Journal of International Casino Studies, August.
2    Gibson, C., 1983. ‘Financial ratios as perceived by commercial loan officers’, Akron Business and Economic Review, Summer, pp.23-27. McConville, D., 1996. ‘Cash flow ratios gains respect as useful tool for credit rating’, Corporate Cashflow Magazine, January, pp.18.
3    Mills, J., and L. Bible, 2002, “Defining Free Cash Flow” The CPA Journal, January.
4    Ibid (McConville 1996).

John Mills is currently a Professor of Accounting at the University of Nevada, Reno. He is also the Director of the Master of Accountancy Program at UNR. Comments and suggestions can be sent to jmills@unr.edu or by phone at (775) 784-6884.