Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that TT Electronics plc (LON:TTG) 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 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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is TT Electronics's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 TT Electronics had UK£113.8m of debt, an increase on UK£80.1m, over one year. However, because it has a cash reserve of UK£51.7m, its net debt is less, at about UK£62.1m.
How Strong Is TT Electronics's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that TT Electronics had liabilities of UK£117.5m due within 12 months and liabilities of UK£140.8m due beyond that. Offsetting these obligations, it had cash of UK£51.7m as well as receivables valued at UK£87.9m due within 12 months. So its liabilities total UK£118.7m more than the combination of its cash and short-term receivables.
This deficit isn't so bad because TT Electronics is worth UK£371.8m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
TT Electronics's net debt is sitting at a very reasonable 2.1 times its EBITDA, while its EBIT covered its interest expense just 4.8 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Shareholders should be aware that TT Electronics's EBIT was down 24% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 TT Electronics 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, TT Electronics recorded free cash flow worth 57% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
TT Electronics's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its conversion of EBIT to free cash flow is relatively strong. Taking the abovementioned factors together we do think TT Electronics's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Given our hesitation about the stock, it would be good to know if TT Electronics 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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