AS Tallinna Sadam (TAL:TSM1T) Takes On Some Risk With Its Use Of Debt

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that AS Tallinna Sadam (TAL:TSM1T) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for AS Tallinna Sadam

What Is AS Tallinna Sadam's Debt?

The chart below, which you can click on for greater detail, shows that AS Tallinna Sadam had €211.6m in debt in September 2020; about the same as the year before. However, because it has a cash reserve of €18.1m, its net debt is less, at about €193.5m.

How Strong Is AS Tallinna Sadam's Balance Sheet?

We can see from the most recent balance sheet that AS Tallinna Sadam had liabilities of €31.9m falling due within a year, and liabilities of €220.6m due beyond that. Offsetting these obligations, it had cash of €18.1m as well as receivables valued at €14.6m due within 12 months. So its liabilities total €219.8m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because AS Tallinna Sadam is worth €468.1m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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).

AS Tallinna Sadam's net debt is 3.3 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 21.8 is very high, suggesting that the interest expense on the debt is currently quite low. Shareholders should be aware that AS Tallinna Sadam's EBIT was down 29% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine AS Tallinna Sadam'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 always check how much of that EBIT is translated into free cash flow. Over the most recent three years, AS Tallinna Sadam recorded free cash flow worth 57% 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

AS Tallinna Sadam's EBIT growth rate and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. It's also worth noting that AS Tallinna Sadam is in the Infrastructure industry, which is often considered to be quite defensive. Looking at all the angles mentioned above, it does seem to us that AS Tallinna Sadam is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Take risks, for example - AS Tallinna Sadam has 2 warning signs we think 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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