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 TFF Group (EPA:TFF) does use debt in its business. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
What Is TFF Group’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of October 2019 TFF Group had €208.7m of debt, an increase on €149.1m, over one year. On the flip side, it has €64.0m in cash leading to net debt of about €144.6m.
A Look At TFF Group’s Liabilities
According to the last reported balance sheet, TFF Group had liabilities of €203.5m due within 12 months, and liabilities of €65.6m due beyond 12 months. Offsetting this, it had €64.0m in cash and €76.3m in receivables that were due within 12 months. So its liabilities total €128.7m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since TFF Group has a market capitalization of €531.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
TFF Group’s net debt is 2.7 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 42.1 is very high, suggesting that the interest expense on the debt is currently quite low. Sadly, TFF Group’s EBIT actually dropped 2.7% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There’s no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if TFF 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.
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. During the last three years, TFF Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Neither TFF Group’s ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think TFF Group’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we’ve spotted 2 warning signs for TFF Group (of which 1 doesn’t sit too well with us!) you should know about.
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.
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.
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