Is Travis Perkins (LON:TPK) Using Too Much 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 note that Travis Perkins plc (LON:TPK) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Travis Perkins

How Much Debt Does Travis Perkins Carry?

The image below, which you can click on for greater detail, shows that at June 2023 Travis Perkins had debt of UK£608.3m, up from UK£453.2m in one year. However, because it has a cash reserve of UK£334.5m, its net debt is less, at about UK£273.8m.

A Look At Travis Perkins' Liabilities

We can see from the most recent balance sheet that Travis Perkins had liabilities of UK£1.32b falling due within a year, and liabilities of UK£967.3m due beyond that. Offsetting these obligations, it had cash of UK£334.5m as well as receivables valued at UK£819.4m due within 12 months. So its liabilities total UK£1.14b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of UK£1.65b, so it does suggest shareholders should keep an eye on Travis Perkins' use of debt. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Looking at its net debt to EBITDA of 0.88 and interest cover of 5.3 times, it seems to us that Travis Perkins is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly, Travis Perkins's EBIT fell a jaw-dropping 24% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Travis Perkins's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. During the last three years, Travis Perkins produced sturdy free cash flow equating to 61% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Travis Perkins's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its net debt to EBITDA is relatively strong. When we consider all the factors discussed, it seems to us that Travis Perkins is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Travis Perkins you should know about.

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.