Is Traffic Technologies (ASX:TTI) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Traffic Technologies Limited (ASX:TTI) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Traffic Technologies

How Much Debt Does Traffic Technologies Carry?

As you can see below, Traffic Technologies had AU$12.2m of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has AU$2.61m in cash leading to net debt of about AU$9.57m.

How Strong Is Traffic Technologies' Balance Sheet?

We can see from the most recent balance sheet that Traffic Technologies had liabilities of AU$24.0m falling due within a year, and liabilities of AU$4.04m due beyond that. Offsetting these obligations, it had cash of AU$2.61m as well as receivables valued at AU$6.01m due within 12 months. So it has liabilities totalling AU$19.4m more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of AU$23.1m, so it does suggest shareholders should keep an eye on Traffic Technologies' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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.

Traffic Technologies shareholders face the double whammy of a high net debt to EBITDA ratio (11.9), and fairly weak interest coverage, since EBIT is just 0.14 times the interest expense. This means we'd consider it to have a heavy debt load. Even worse, Traffic Technologies saw its EBIT tank 26% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Traffic Technologies's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Traffic Technologies recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both Traffic Technologies's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least its conversion of EBIT to free cash flow is not so bad. We should also note that Infrastructure industry companies like Traffic Technologies commonly do use debt without problems. Overall, it seems to us that Traffic Technologies's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example - Traffic Technologies has 2 warning signs we think 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. 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.
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