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Is Tesla (NASDAQ:TSLA) A Risky Investment?

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Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Tesla, Inc. (NASDAQ:TSLA) does carry debt. But the more important question is: how much risk is that debt creating?

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. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Tesla

How Much Debt Does Tesla Carry?

The image below, which you can click on for greater detail, shows that Tesla had debt of US$11.4b at the end of June 2019, a reduction from US$13.4b over a year. However, because it has a cash reserve of US$4.95b, its net debt is less, at about US$6.46b.

NasdaqGS:TSLA Historical Debt, September 26th 2019
NasdaqGS:TSLA Historical Debt, September 26th 2019

A Look At Tesla's Liabilities

The latest balance sheet data shows that Tesla had liabilities of US$9.59b due within a year, and liabilities of US$15.1b falling due after that. Offsetting these obligations, it had cash of US$4.95b as well as receivables valued at US$1.15b due within 12 months. So it has liabilities totalling US$18.6b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Tesla is worth a massive US$41.0b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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).

While Tesla's debt to EBITDA ratio (2.8) suggests that it uses some debt, its interest cover is very weak, at 0.49, suggesting high leverage. 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 seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, the silver lining was that Tesla achieved a positive EBIT of US$334m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Tesla'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 company can only pay off debt with cold hard cash, not accounting profits. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Tesla actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Tesla's interest cover was a real negative on this analysis, although the other factors we considered were considerably better There's no doubt that its ability to convert EBIT to free cash flow is pretty flash. Looking at all this data makes us feel a little cautious about Tesla's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. We'd be motivated to research the stock further if we found out that Tesla 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.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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.