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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Shenandoah Telecommunications Company (NASDAQ:SHEN) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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. 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.
What Is Shenandoah Telecommunications's Net Debt?
You can click the graphic below for the historical numbers, but it shows that Shenandoah Telecommunications had US$747.0m of debt in June 2019, down from US$799.9m, one year before. However, because it has a cash reserve of US$100.4m, its net debt is less, at about US$646.6m.
How Strong Is Shenandoah Telecommunications's Balance Sheet?
We can see from the most recent balance sheet that Shenandoah Telecommunications had liabilities of US$127.8m falling due within a year, and liabilities of US$1.23b due beyond that. On the other hand, it had cash of US$100.4m and US$107.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.15b.
This deficit is considerable relative to its market capitalization of US$1.71b, so it does suggest shareholders should keep an eye on Shenandoah Telecommunications's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Shenandoah Telecommunications's net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 3.2 times last year. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It is well worth noting that Shenandoah Telecommunications's EBIT shot up like bamboo after rain, gaining 37% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Shenandoah Telecommunications's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Shenandoah Telecommunications actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
The good news is that Shenandoah Telecommunications's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But truth be told we feel its interest cover does undermine this impression a bit. All these things considered, it appears that Shenandoah Telecommunications can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. We'd be motivated to research the stock further if we found out that Shenandoah Telecommunications insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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