Does Tallinna Kaubamaja Grupp (TAL:TKM1T) Have A Healthy Balance Sheet?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Tallinna Kaubamaja Grupp AS (TAL:TKM1T) does use debt in its business. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 Tallinna Kaubamaja Grupp

What Is Tallinna Kaubamaja Grupp's Debt?

As you can see below, at the end of September 2020, Tallinna Kaubamaja Grupp had €126.5m of debt, up from €102.2m a year ago. Click the image for more detail. However, it does have €22.7m in cash offsetting this, leading to net debt of about €103.8m.

A Look At Tallinna Kaubamaja Grupp's Liabilities

We can see from the most recent balance sheet that Tallinna Kaubamaja Grupp had liabilities of €114.5m falling due within a year, and liabilities of €252.5m due beyond that. Offsetting these obligations, it had cash of €22.7m as well as receivables valued at €12.6m due within 12 months. So its liabilities total €331.6m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of €386.1m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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.

Tallinna Kaubamaja Grupp has net debt to EBITDA of 3.1 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 8.4 times its interest expense, and its net debt to EBITDA, was quite high, at 3.1. The bad news is that Tallinna Kaubamaja Grupp saw its EBIT decline by 18% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Tallinna Kaubamaja Grupp will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Happily for any shareholders, Tallinna Kaubamaja Grupp actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

Neither Tallinna Kaubamaja Grupp's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Taking the abovementioned factors together we do think Tallinna Kaubamaja Grupp's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. Be aware that Tallinna Kaubamaja Grupp is showing 2 warning signs in our investment analysis , 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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