U.S. Markets open in 54 mins

Is Ternium (NYSE:TX) Using Too Much Debt?

Simply Wall St

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Ternium S.A. (NYSE:TX) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Ternium

How Much Debt Does Ternium Carry?

As you can see below, Ternium had US$2.56b of debt at June 2019, down from US$2.86b a year prior. On the flip side, it has US$806.2m in cash leading to net debt of about US$1.75b.

NYSE:TX Historical Debt, August 13th 2019

How Strong Is Ternium's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Ternium had liabilities of US$2.14b due within 12 months and liabilities of US$3.67b due beyond that. Offsetting this, it had US$806.2m in cash and US$1.68b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.33b.

This is a mountain of leverage relative to its market capitalization of US$3.36b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Ternium has a low net debt to EBITDA ratio of only 0.79. And its EBIT covers its interest expense a whopping 18.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On the other hand, Ternium saw its EBIT drop by 5.2% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Ternium 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Ternium's free cash flow amounted to 37% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Ternium's ability to handle its total liabilities nor its EBIT growth rate gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Ternium is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Ternium's dividend history, without delay!

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.