Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk. It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies The Toro Company (NYSE:TTC) makes use of debt. But the more important question is: how much risk is that debt creating?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Toro Carry?
The image below, which you can click on for greater detail, shows that at August 2019 Toro had debt of US$720.7m, up from US$312.5m in one year. On the flip side, it has US$143.3m in cash leading to net debt of about US$577.4m.
How Healthy Is Toro’s Balance Sheet?
The latest balance sheet data shows that Toro had liabilities of US$756.4m due within a year, and liabilities of US$709.5m falling due after that. On the other hand, it had cash of US$143.3m and US$312.2m worth of receivables due within a year. So it has liabilities totalling US$1.01b more than its cash and near-term receivables, combined.
Since publicly traded Toro shares are worth a total of US$8.27b, 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.
Toro has a low net debt to EBITDA ratio of only 1.2. And its EBIT easily covers its interest expense, being 16.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Toro’s EBIT was pretty flat over the last year, but that shouldn’t be an issue given the it doesn’t have a lot of 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 Toro 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Toro produced sturdy free cash flow equating to 76% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Toro’s impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at the bigger picture, we think Toro’s use of debt seems quite reasonable and we’re not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Toro insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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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