Stock Analysis

Here's Why TC Energy (TSE:TRP) Is Weighed Down By Its Debt Load

TSX:TRP
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Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies TC Energy Corporation (TSE:TRP) makes use of debt. But the more important question is: how much risk is that debt creating?

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When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

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What Is TC Energy's Debt?

As you can see below, TC Energy had CA$49.7b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CA$1.49b in cash leading to net debt of about CA$48.2b.

debt-equity-history-analysis
TSX:TRP Debt to Equity History December 16th 2020

A Look At TC Energy's Liabilities

According to the last reported balance sheet, TC Energy had liabilities of CA$10.1b due within 12 months, and liabilities of CA$57.1b due beyond 12 months. On the other hand, it had cash of CA$1.49b and CA$2.61b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$63.1b.

When you consider that this deficiency exceeds the company's huge CA$53.0b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

TC Energy has a rather high debt to EBITDA ratio of 5.8 which suggests a meaningful debt load. However, its interest coverage of 2.7 is reasonably strong, which is a good sign. More concerning, TC Energy saw its EBIT drop by 8.2% in the last twelve months. If that earnings trend continues the company will face an uphill battle to pay off its 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 TC Energy'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. During the last three years, TC Energy burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, TC Energy's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. And even its interest cover fails to inspire much confidence. After considering the datapoints discussed, we think TC Energy has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. Be aware that TC Energy is showing 1 warning sign in our investment analysis , you should know about...

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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