Is Transurban Group (ASX:TCL) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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, Transurban Group (ASX:TCL) does carry 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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out the opportunities and risks within the AU Infrastructure industry.

How Much Debt Does Transurban Group Carry?

The chart below, which you can click on for greater detail, shows that Transurban Group had AU$17.9b in debt in June 2022; about the same as the year before. However, it does have AU$2.04b in cash offsetting this, leading to net debt of about AU$15.8b.

How Healthy Is Transurban Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Transurban Group had liabilities of AU$3.49b due within 12 months and liabilities of AU$20.2b due beyond that. On the other hand, it had cash of AU$2.04b and AU$291.0m worth of receivables due within a year. So its liabilities total AU$21.4b 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$38.6b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 0.89 times and a disturbingly high net debt to EBITDA ratio of 9.4 hit our confidence in Transurban Group like a one-two punch to the gut. The debt burden here is substantial. Fortunately, Transurban Group grew its EBIT by 5.6% 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 it is future earnings, more than anything, that will determine Transurban Group's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Transurban Group recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

To be frank both Transurban Group's net debt to EBITDA and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. It's also worth noting that Transurban Group is in the Infrastructure industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that Transurban Group's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Transurban Group is showing 3 warning signs in our investment analysis , and 2 of those are significant...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.