Is TOD'S (BIT:TOD) A Risky Investment?

Want to participate in a short research study? Help shape the future of investing tools and you could win a $250 gift card!

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 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 note that TOD'S S.p.A. (BIT:TOD) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for TOD'S

What Is TOD'S's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2018 TOD'S had debt of €277.1m, up from €225.2m in one year. However, it also had €191.3m in cash, and so its net debt is €85.8m.

How Strong Is TOD'S's Balance Sheet?

The latest balance sheet data shows that TOD'S had liabilities of €391.8m due within a year, and liabilities of €160.5m falling due after that. Offsetting these obligations, it had cash of €191.3m as well as receivables valued at €112.8m due within 12 months. So its liabilities total €248.2m more than the combination of its cash and short-term receivables.

Given TOD'S has a market capitalization of €1.38b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. Since TOD'S does have net debt, we think it is worthwhile for shareholders to keep an eye on the balance sheet, over time.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

TOD'S's net debt is only 0.76 times its EBITDA. And its EBIT covers its interest expense a whopping 90.0 times over. So we're pretty relaxed about its super-conservative use of debt. The modesty of its debt load may become crucial for TOD'S if management cannot prevent a repeat of the 36% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine TOD'S's ability to maintain a healthy balance sheet going forward. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, TOD'S saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both TOD'S's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that TOD'S's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. Given our hesitation about the stock, it would be good to know if TOD'S insiders have sold any shares recently. You click here to find out if insiders have sold recently.

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.

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.