Is Transcontinental (TSE:TCL.A) A Risky Investment?

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. As with many other companies Transcontinental Inc. (TSE:TCL.A) makes use of debt. But is this debt a concern to shareholders?

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. If things get really bad, the lenders can take control of the business. 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. 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 Transcontinental

What Is Transcontinental's Debt?

You can click the graphic below for the historical numbers, but it shows that as of October 2022 Transcontinental had CA$1.03b of debt, an increase on CA$896.7m, over one year. However, it also had CA$45.7m in cash, and so its net debt is CA$984.5m.

How Healthy Is Transcontinental's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Transcontinental had liabilities of CA$547.0m due within 12 months and liabilities of CA$1.37b due beyond that. Offsetting this, it had CA$45.7m in cash and CA$587.9m in receivables that were due within 12 months. So it has liabilities totalling CA$1.29b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of CA$1.23b, we think shareholders really should watch Transcontinental's debt levels, like a parent watching their child ride a bike for the first time. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Transcontinental's net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 5.9 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Unfortunately, Transcontinental saw its EBIT slide 10.0% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Transcontinental can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. During the last three years, Transcontinental produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Transcontinental's level of total liabilities and EBIT growth rate definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. When we consider all the factors discussed, it seems to us that Transcontinental is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. Case in point: We've spotted 3 warning signs for Transcontinental 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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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.