Is TerraCom (ASX:TER) Using Too Much Debt?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, TerraCom Limited (ASX:TER) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for TerraCom

How Much Debt Does TerraCom Carry?

As you can see below, TerraCom had AU$4.90m of debt at December 2023, down from AU$8.55m a year prior. But it also has AU$16.6m in cash to offset that, meaning it has AU$11.7m net cash.

A Look At TerraCom's Liabilities

Zooming in on the latest balance sheet data, we can see that TerraCom had liabilities of AU$85.9m due within 12 months and liabilities of AU$75.2m due beyond that. Offsetting these obligations, it had cash of AU$16.6m as well as receivables valued at AU$23.1m due within 12 months. So its liabilities total AU$121.4m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because TerraCom is worth AU$212.3m, 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. While it does have liabilities worth noting, TerraCom also has more cash than debt, so we're pretty confident it can manage its debt safely.

In fact TerraCom's saving grace is its low debt levels, because its EBIT has tanked 73% in the last twelve months. When a company sees its earnings tank, it can sometimes find its relationships with its lenders turn sour. The balance sheet is clearly the area to focus on when you are analysing debt. But it is TerraCom's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While TerraCom has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. During the last three years, TerraCom produced sturdy free cash flow equating to 72% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Summing Up

While TerraCom does have more liabilities than liquid assets, it also has net cash of AU$11.7m. The cherry on top was that in converted 72% of that EBIT to free cash flow, bringing in -AU$15m. So we are not troubled with TerraCom's debt use. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for TerraCom (1 is potentially serious) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.