Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies TerraVest Industries Inc. (TSE:TVK) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does TerraVest Industries Carry?
As you can see below, TerraVest Industries had CA$105.3m of debt at September 2020, down from CA$120.1m a year prior. However, it also had CA$27.5m in cash, and so its net debt is CA$77.8m.
A Look At TerraVest Industries' Liabilities
The latest balance sheet data shows that TerraVest Industries had liabilities of CA$56.3m due within a year, and liabilities of CA$137.1m falling due after that. On the other hand, it had cash of CA$27.5m and CA$45.4m worth of receivables due within a year. So it has liabilities totalling CA$120.6m more than its cash and near-term receivables, combined.
This deficit isn't so bad because TerraVest Industries is worth CA$292.0m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
TerraVest Industries's net debt is sitting at a very reasonable 1.5 times its EBITDA, while its EBIT covered its interest expense just 6.9 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. But the other side of the story is that TerraVest Industries saw its EBIT decline by 3.4% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is TerraVest Industries's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, TerraVest Industries recorded free cash flow worth 63% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
TerraVest Industries's conversion of EBIT to free cash flow was a real positive on this analysis, as was its interest cover. Having said that, its EBIT growth rate somewhat sensitizes us to potential future risks to the balance sheet. Looking at all this data makes us feel a little cautious about TerraVest Industries's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 2 warning signs for TerraVest Industries that you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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