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. 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. As with many other companies Tech Data Corporation (NASDAQ:TECD) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Tech Data’s Debt?
The image below, which you can click on for greater detail, shows that Tech Data had debt of US$1.43b at the end of July 2019, a reduction from US$1.52b over a year. On the flip side, it has US$738.3m in cash leading to net debt of about US$687.4m.
How Strong Is Tech Data’s Balance Sheet?
According to the last reported balance sheet, Tech Data had liabilities of US$7.58b due within 12 months, and liabilities of US$1.59b due beyond 12 months. Offsetting these obligations, it had cash of US$738.3m as well as receivables valued at US$5.39b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$3.04b.
This deficit is considerable relative to its market capitalization of US$4.35b, so it does suggest shareholders should keep an eye on Tech Data’s use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
Looking at its net debt to EBITDA of 0.92 and interest cover of 6.3 times, it seems to us that Tech Data is probably using debt in a pretty reasonable way. So we’d recommend keeping a close eye on the impact financing costs are having on the business. Another good sign is that Tech Data has been able to increase its EBIT by 24% in twelve months, making it easier to pay down debt. 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 Tech Data 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 it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Tech Data actually produced more free cash flow than EBIT. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
The good news is that Tech Data’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. When we consider the range of factors above, it looks like Tech Data is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. We’d be motivated to research the stock further if we found out that Tech Data 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.
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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.