TerraCom (ASX:TER) Could Easily Take On More Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. We can see that TerraCom Limited (ASX:TER) does use debt in its business. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for TerraCom

How Much Debt Does TerraCom Carry?

You can click the graphic below for the historical numbers, but it shows that TerraCom had AU$8.55m of debt in December 2022, down from AU$268.6m, one year before. However, its balance sheet shows it holds AU$99.0m in cash, so it actually has AU$90.4m net cash.

A Look At TerraCom's Liabilities

According to the last reported balance sheet, TerraCom had liabilities of AU$164.6m due within 12 months, and liabilities of AU$82.4m due beyond 12 months. Offsetting these obligations, it had cash of AU$99.0m as well as receivables valued at AU$33.1m due within 12 months. So its liabilities total AU$114.8m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because TerraCom is worth AU$428.5m, 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.

Better yet, TerraCom grew its EBIT by 267% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since TerraCom will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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 two years, TerraCom generated free cash flow amounting to a very robust 90% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Summing Up

Although TerraCom's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$90.4m. And it impressed us with free cash flow of AU$448m, being 90% of its EBIT. So is TerraCom's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with TerraCom , and understanding them should be part of your investment process.

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.

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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.