Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about. 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. We can see that Treasury Wine Estates Limited (ASX:TWE) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Treasury Wine Estates's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Treasury Wine Estates had debt of AU$1.17b, up from AU$879.6m in one year. On the flip side, it has AU$401.8m in cash leading to net debt of about AU$763.3m.
A Look At Treasury Wine Estates's Liabilities
According to the last reported balance sheet, Treasury Wine Estates had liabilities of AU$885.0m due within 12 months, and liabilities of AU$1.41b due beyond 12 months. Offsetting these obligations, it had cash of AU$401.8m as well as receivables valued at AU$634.6m due within 12 months. So its liabilities total AU$1.26b more than the combination of its cash and short-term receivables.
Since publicly traded Treasury Wine Estates shares are worth a total of AU$13.2b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Treasury Wine Estates's net debt is only 1.0 times its EBITDA. And its EBIT easily covers its interest expense, being 12.9 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Treasury Wine Estates grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. 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 Treasury Wine Estates 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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Treasury Wine Estates recorded free cash flow of 31% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
Happily, Treasury Wine Estates's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. When we consider the range of factors above, it looks like Treasury Wine Estates is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Treasury Wine Estates insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.