Is TORM (CPH:TRMD A) Using Too Much Debt?

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.' 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. We can see that TORM plc (CPH:TRMD A) does use debt in its business. But should shareholders be worried about its use of debt?

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

What Is TORM's Debt?

The image below, which you can click on for greater detail, shows that at December 2021 TORM had debt of US$1.13b, up from US$834.1m in one year. On the flip side, it has US$144.8m in cash leading to net debt of about US$985.0m.

How Strong Is TORM's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that TORM had liabilities of US$307.2m due within 12 months and liabilities of US$971.6m due beyond that. Offsetting these obligations, it had cash of US$144.8m as well as receivables valued at US$88.2m due within 12 months. So its liabilities total US$1.05b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of US$709.7m, we think shareholders really should watch TORM'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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 0.15 times and a disturbingly high net debt to EBITDA ratio of 7.3 hit our confidence in TORM like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, TORM's EBIT was down 96% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if TORM 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, TORM saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both TORM's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. Considering everything we've mentioned above, it's fair to say that TORM is carrying heavy debt load. If you play with fire you risk getting burnt, so we'd probably give this stock a wide berth. 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. For example TORM has 3 warning signs (and 1 which is concerning) we think you should know about.

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.