Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that Tabcorp Holdings Limited (ASX:TAH) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Tabcorp Holdings Carry?
As you can see below, Tabcorp Holdings had AU$3.81b of debt at December 2018, down from AU$3.98b a year prior. However, it does have AU$413.9m in cash offsetting this, leading to net debt of about AU$3.40b.
How Strong Is Tabcorp Holdings's Balance Sheet?
The latest balance sheet data shows that Tabcorp Holdings had liabilities of AU$1.50b due within a year, and liabilities of AU$4.42b falling due after that. On the other hand, it had cash of AU$413.9m and AU$155.7m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$5.35b.
This deficit is considerable relative to its market capitalization of AU$8.83b, so it does suggest shareholders should keep an eye on Tabcorp Holdings's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Tabcorp Holdings has a debt to EBITDA ratio of 4.4 and its EBIT covered its interest expense 3.2 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. The silver lining is that Tabcorp Holdings grew its EBIT by 110% last year, which nourishing like the idealism of youth. If that earnings trend continues it will make its debt load much more manageable in the future. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Tabcorp Holdings 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Tabcorp Holdings recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Tabcorp Holdings's net debt to EBITDA and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. We think that Tabcorp Holdings's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. Given our hesitation about the stock, it would be good to know if Tabcorp Holdings insiders have sold any shares recently. You click here to find out if insiders have sold recently.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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