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.’ 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. We note that Toromont Industries Ltd. (TSE:TIH) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
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What Is Toromont Industries’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 Toromont Industries had CA$736.0m of debt, an increase on CA$645.0m, over one year. However, it also had CA$537.2m in cash, and so its net debt is CA$198.8m.
How Strong Is Toromont Industries’s Balance Sheet?
The latest balance sheet data shows that Toromont Industries had liabilities of CA$937.7m due within a year, and liabilities of CA$974.7m falling due after that. Offsetting these obligations, it had cash of CA$537.2m as well as receivables valued at CA$462.1m due within 12 months. So its liabilities total CA$913.1m more than the combination of its cash and short-term receivables.
Of course, Toromont Industries has a market capitalization of CA$6.33b, so these liabilities are probably manageable. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Toromont Industries’s net debt is only 0.38 times its EBITDA. And its EBIT covers its interest expense a whopping 19.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Toromont Industries saw its EBIT decline by 5.4% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Toromont Industries’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, Toromont Industries recorded free cash flow worth a fulsome 87% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
Our View
The good news is that Toromont Industries’s demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its EBIT growth rate. When we consider the range of factors above, it looks like Toromont Industries is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example – Toromont Industries has 2 warning signs we think you should be aware of.
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.
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