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. As with many other companies TalkTalk Telecom Group PLC (LON:TALK) makes use of debt. But should shareholders be worried about its use of debt?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is TalkTalk Telecom Group's Debt?
The chart below, which you can click on for greater detail, shows that TalkTalk Telecom Group had UK£809.0m in debt in March 2019; about the same as the year before. However, it also had UK£67.0m in cash, and so its net debt is UK£742.0m.
A Look At TalkTalk Telecom Group's Liabilities
Zooming in on the latest balance sheet data, we can see that TalkTalk Telecom Group had liabilities of UK£563.0m due within 12 months and liabilities of UK£855.0m due beyond that. On the other hand, it had cash of UK£67.0m and UK£179.0m worth of receivables due within a year. So it has liabilities totalling UK£1.17b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company's UK£1.16b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner's social media. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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.
While we wouldn't worry about TalkTalk Telecom Group's net debt to EBITDA ratio of 3.1, we think its super-low interest cover of 2.5 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. The good news is that TalkTalk Telecom Group improved its EBIT by 2.7% over the last twelve years, thus gradually reducing its debt levels relative to its earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if TalkTalk Telecom Group can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, TalkTalk Telecom Group recorded free cash flow of 35% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
To be frank both TalkTalk Telecom Group's level of total liabilities and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. Looking at the bigger picture, it seems clear to us that TalkTalk Telecom Group's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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