David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Shenandoah Telecommunications Company (NASDAQ:SHEN) does use debt in its business. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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 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. 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 Shenandoah Telecommunications’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that Shenandoah Telecommunications had US$709.7m of debt in June 2020, down from US$747.0m, one year before. However, it also had US$143.7m in cash, and so its net debt is US$566.0m.
How Strong Is Shenandoah Telecommunications’s Balance Sheet?
We can see from the most recent balance sheet that Shenandoah Telecommunications had liabilities of US$145.3m falling due within a year, and liabilities of US$1.22b due beyond that. Offsetting this, it had US$143.7m in cash and US$140.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.1b.
While this might seem like a lot, it is not so bad since Shenandoah Telecommunications has a market capitalization of US$2.76b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Shenandoah Telecommunications’s net debt is sitting at a very reasonable 2.1 times its EBITDA, while its EBIT covered its interest expense just 5.5 times last year. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. Shenandoah Telecommunications grew its EBIT by 9.8% in the last year. That’s far from incredible but it is a good thing, when it comes to paying off 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 Shenandoah Telecommunications 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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Shenandoah Telecommunications actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Shenandoah Telecommunications’s conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And its EBIT growth rate is good too. Looking at all the aforementioned factors together, it strikes us that Shenandoah Telecommunications can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. There’s no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet – far from it. To that end, you should be aware of the 1 warning sign we’ve spotted with Shenandoah Telecommunications .
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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