Does Tornado Global Hydrovacs (CVE:TGH) Have A Healthy Balance Sheet?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Tornado Global Hydrovacs Ltd. (CVE:TGH) 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 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Tornado Global Hydrovacs

What Is Tornado Global Hydrovacs's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2020 Tornado Global Hydrovacs had debt of CA$6.46m, up from CA$375.0k in one year. However, it does have CA$4.51m in cash offsetting this, leading to net debt of about CA$1.95m.

How Healthy Is Tornado Global Hydrovacs' Balance Sheet?

The latest balance sheet data shows that Tornado Global Hydrovacs had liabilities of CA$11.3m due within a year, and liabilities of CA$1.68m falling due after that. On the other hand, it had cash of CA$4.51m and CA$2.90m worth of receivables due within a year. So it has liabilities totalling CA$5.53m more than its cash and near-term receivables, combined.

Since publicly traded Tornado Global Hydrovacs shares are worth a total of CA$29.2m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Given net debt is only 1.2 times EBITDA, it is initially surprising to see that Tornado Global Hydrovacs's EBIT has low interest coverage of 1.4 times. So while we're not necessarily alarmed we think that its debt is far from trivial. Shareholders should be aware that Tornado Global Hydrovacs's EBIT was down 82% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Tornado Global Hydrovacs 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Happily for any shareholders, Tornado Global Hydrovacs actually produced more free cash flow than EBIT over the last two years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Neither Tornado Global Hydrovacs's ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Looking at all the angles mentioned above, it does seem to us that Tornado Global Hydrovacs is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Tornado Global Hydrovacs , and understanding them should be part of your investment process.

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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