Transcontinental (TSE:TCL.A) Has A Somewhat Strained Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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, Transcontinental Inc. (TSE:TCL.A) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Transcontinental

What Is Transcontinental's Debt?

The image below, which you can click on for greater detail, shows that at April 2023 Transcontinental had debt of CA$1.08b, up from CA$893.6m in one year. However, it does have CA$36.4m in cash offsetting this, leading to net debt of about CA$1.05b.

How Strong Is Transcontinental's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Transcontinental had liabilities of CA$467.8m due within 12 months and liabilities of CA$1.37b due beyond that. Offsetting these obligations, it had cash of CA$36.4m as well as receivables valued at CA$565.5m due within 12 months. So its liabilities total CA$1.24b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of CA$1.09b, we think shareholders really should watch Transcontinental's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

Transcontinental's debt is 2.6 times its EBITDA, and its EBIT cover its interest expense 4.5 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly Transcontinental's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Transcontinental'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Transcontinental recorded free cash flow worth 69% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Neither Transcontinental's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. 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. 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 Transcontinental is showing 1 warning sign in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.