Treasury Wine Estates (ASX:TWE) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Treasury Wine Estates Limited (ASX:TWE) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Treasury Wine Estates

How Much Debt Does Treasury Wine Estates Carry?

As you can see below, at the end of June 2022, Treasury Wine Estates had AU$1.06b of debt, up from AU$915.2m a year ago. Click the image for more detail. However, because it has a cash reserve of AU$430.5m, its net debt is less, at about AU$634.2m.

How Healthy Is Treasury Wine Estates' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Treasury Wine Estates had liabilities of AU$1.00b due within 12 months and liabilities of AU$1.87b due beyond that. On the other hand, it had cash of AU$430.5m and AU$515.1m worth of receivables due within a year. So it has liabilities totalling AU$1.93b more than its cash and near-term receivables, combined.

Treasury Wine Estates has a market capitalization of AU$9.45b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

With net debt sitting at just 1.1 times EBITDA, Treasury Wine Estates is arguably pretty conservatively geared. And it boasts interest cover of 7.2 times, which is more than adequate. Fortunately, Treasury Wine Estates grew its EBIT by 4.6% in the last year, making that debt load look even more manageable. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Treasury Wine Estates's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Treasury Wine Estates recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Treasury Wine Estates's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And we also thought its net debt to EBITDA was a positive. Looking at all the aforementioned factors together, it strikes us that Treasury Wine Estates can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Over time, share prices tend to follow earnings per share, so if you're interested in Treasury Wine Estates, you may well want to click here to check an interactive graph of its earnings per share history.

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.