Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Thomson Reuters Corporation (TSE:TRI) makes use of debt. But should shareholders be worried about its use of debt?
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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
What Is Thomson Reuters's Net Debt?
The chart below, which you can click on for greater detail, shows that Thomson Reuters had US$3.79b in debt in March 2021; about the same as the year before. However, it does have US$2.66b in cash offsetting this, leading to net debt of about US$1.13b.
How Strong Is Thomson Reuters' Balance Sheet?
We can see from the most recent balance sheet that Thomson Reuters had liabilities of US$3.18b falling due within a year, and liabilities of US$5.79b due beyond that. On the other hand, it had cash of US$2.66b and US$1.05b worth of receivables due within a year. So its liabilities total US$5.25b more than the combination of its cash and short-term receivables.
Given Thomson Reuters has a humongous market capitalization of US$47.9b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Thomson Reuters's net debt is only 0.78 times its EBITDA. And its EBIT covers its interest expense a whopping 18.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that Thomson Reuters has been able to increase its EBIT by 27% in twelve months, making it easier to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Thomson Reuters'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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Thomson Reuters recorded free cash flow worth a fulsome 98% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Thomson Reuters's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Overall, we don't think Thomson Reuters is taking any bad risks, as its debt load seems modest. So we're not worried about the use of a little leverage on the balance sheet. 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. We've identified 4 warning signs with Thomson Reuters (at least 2 which are concerning) , and understanding them should be part of your investment process.
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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