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. 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 Transurban Group (ASX:TCL) makes use of debt. But the real question is whether this debt is making the company risky.
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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Transurban Group Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Transurban Group had debt of AU$19.0b, up from AU$15.8k in one year. However, it does have AU$1.64b in cash offsetting this, leading to net debt of about AU$17.3b.
How Healthy Is Transurban Group’s Balance Sheet?
According to the last reported balance sheet, Transurban Group had liabilities of AU$3.79b due within 12 months, and liabilities of AU$22.3b due beyond 12 months. On the other hand, it had cash of AU$1.64b and AU$238.0m worth of receivables due within a year. So its liabilities total AU$24.2b more than the combination of its cash and short-term receivables.
This deficit isn’t so bad because Transurban Group is worth a massive AU$40.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
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).
Weak interest cover of 1.4 times and a disturbingly high net debt to EBITDA ratio of 8.6 hit our confidence in Transurban Group like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. Fortunately, Transurban Group grew its EBIT by 2.7% in the last year, slowly shrinking its debt relative to earnings. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Transurban Group 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Transurban Group burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Transurban Group’s net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. We should also note that Infrastructure industry companies like Transurban Group commonly do use debt without problems. We’re quite clear that we consider Transurban Group to be really rather risky, as a result of its balance sheet health. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
Of course, if you’re the type of investor who prefers buying stocks without the burden of debt, then don’t hesitate to discover our exclusive list of net cash growth stocks, today.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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.
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