We Think Tree Island Steel (TSE:TSL) Can Stay On Top Of Its 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Tree Island Steel Ltd. (TSE:TSL) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Tree Island Steel

How Much Debt Does Tree Island Steel Carry?

As you can see below, Tree Island Steel had CA$48.6m of debt, at June 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has CA$3.59m in cash leading to net debt of about CA$45.0m.

How Healthy Is Tree Island Steel's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Tree Island Steel had liabilities of CA$29.9m due within 12 months and liabilities of CA$77.3m due beyond that. On the other hand, it had cash of CA$3.59m and CA$36.0m worth of receivables due within a year. So it has liabilities totalling CA$67.6m more than its cash and near-term receivables, combined.

This deficit isn't so bad because Tree Island Steel is worth CA$131.7m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Tree Island Steel has net debt of just 1.4 times EBITDA, indicating that it is certainly not a reckless borrower. And it boasts interest cover of 7.7 times, which is more than adequate. Even more impressive was the fact that Tree Island Steel grew its EBIT by 393% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is Tree Island Steel's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Tree Island Steel recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Happily, Tree Island Steel's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. Looking at the bigger picture, we think Tree Island Steel's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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. We've identified 4 warning signs with Tree Island Steel (at least 2 which make us uncomfortable) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.
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