TerraCom (ASX:TER) Seems To Use Debt Quite Sensibly

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 more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we think about a company's use of debt, we first look at cash and debt together.

See 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$6.25m of debt in June 2023, down from AU$36.9m, one year before. However, it does have AU$44.0m in cash offsetting this, leading to net cash of AU$37.8m.

How Strong Is TerraCom's Balance Sheet?

We can see from the most recent balance sheet that TerraCom had liabilities of AU$113.8m falling due within a year, and liabilities of AU$74.5m due beyond that. Offsetting these obligations, it had cash of AU$44.0m as well as receivables valued at AU$19.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$125.2m.

While this might seem like a lot, it is not so bad since TerraCom has a market capitalization of AU$320.4m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt. 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.

On the other hand, TerraCom saw its EBIT drop by 9.1% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. TerraCom may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last two years, TerraCom 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.

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$37.8m. And it impressed us with free cash flow of AU$191m, being 76% of its EBIT. So we are not troubled with TerraCom's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. 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 a bit unpleasant) 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.