Is Touchstone Exploration (TSE:TXP) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 Touchstone Exploration Inc. (TSE:TXP) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

Check out our latest analysis for Touchstone Exploration

What Is Touchstone Exploration's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2022 Touchstone Exploration had debt of US$29.9m, up from US$7.19m in one year. On the flip side, it has US$10.1m in cash leading to net debt of about US$19.8m.

A Look At Touchstone Exploration's Liabilities

Zooming in on the latest balance sheet data, we can see that Touchstone Exploration had liabilities of US$18.1m due within 12 months and liabilities of US$54.4m due beyond that. On the other hand, it had cash of US$10.1m and US$9.52m worth of receivables due within a year. So its liabilities total US$52.8m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Touchstone Exploration has a market capitalization of US$216.2m, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While we wouldn't worry about Touchstone Exploration's net debt to EBITDA ratio of 2.7, we think its super-low interest cover of 2.5 times is a sign of high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. One redeeming factor for Touchstone Exploration is that it turned last year's EBIT loss into a gain of US$3.4m, over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Touchstone Exploration's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Touchstone Exploration saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

Mulling over Touchstone Exploration's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. Having said that, its ability to handle its total liabilities isn't such a worry. Once we consider all the factors above, together, it seems to us that Touchstone Exploration's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 2 warning signs we've spotted with Touchstone Exploration (including 1 which is potentially serious) .

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.