Warren Buffett famously said, '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 Tesmec S.p.A. (BIT:TES) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Tesmec Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Tesmec had €123.0m of debt, an increase on €116.6m, over one year. However, it does have €21.5m in cash offsetting this, leading to net debt of about €101.5m.
A Look At Tesmec's Liabilities
According to the last reported balance sheet, Tesmec had liabilities of €173.5m due within 12 months, and liabilities of €76.4m due beyond 12 months. On the other hand, it had cash of €21.5m and €89.0m worth of receivables due within a year. So it has liabilities totalling €139.4m more than its cash and near-term receivables, combined.
This deficit casts a shadow over the €42.4m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt After all, Tesmec would likely require a major re-capitalisation if it had to pay its creditors today.
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.
Weak interest cover of 0.88 times and a disturbingly high net debt to EBITDA ratio of 12.1 hit our confidence in Tesmec like a one-two punch to the gut. The debt burden here is substantial. Even worse, Tesmec saw its EBIT tank 42% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Tesmec 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last two years, Tesmec burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Tesmec's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And even its interest cover fails to inspire much confidence. It looks to us like Tesmec carries a significant balance sheet burden. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Tesmec's earnings per share history 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 email@example.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.