These 4 Measures Indicate That Touchstone Exploration (TSE:TXP) Is Using Debt Extensively

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Touchstone Exploration Inc. (TSE:TXP) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Touchstone Exploration

What Is Touchstone Exploration's Net Debt?

As you can see below, at the end of June 2022, Touchstone Exploration had US$29.9m of debt, up from US$7.21m a year ago. Click the image for more detail. However, because it has a cash reserve of US$9.43m, its net debt is less, at about US$20.5m.

How Healthy Is Touchstone Exploration's Balance Sheet?

We can see from the most recent balance sheet that Touchstone Exploration had liabilities of US$20.4m falling due within a year, and liabilities of US$53.4m due beyond that. Offsetting this, it had US$9.43m in cash and US$9.19m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$55.1m.

While this might seem like a lot, it is not so bad since Touchstone Exploration has a market capitalization of US$198.5m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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

Touchstone Exploration has net debt worth 2.2 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 2.8 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Notably, Touchstone Exploration made a loss at the EBIT level, last year, but improved that to positive EBIT of US$5.2m in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Touchstone Exploration can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. During the last year, Touchstone Exploration 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

Mulling over Touchstone Exploration's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least its level of total liabilities is not so bad. Once we consider all the factors above, together, it seems to us that Touchstone Exploration's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Touchstone Exploration (1 is potentially serious!) that you should be aware of before investing here.

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. 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.