Travis Perkins (LON:TPK) Could Easily Take On More 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Travis Perkins plc (LON:TPK) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Travis Perkins

What Is Travis Perkins's Debt?

The chart below, which you can click on for greater detail, shows that Travis Perkins had UK£575.2m in debt in December 2021; about the same as the year before. However, it does have UK£459.8m in cash offsetting this, leading to net debt of about UK£115.4m.

A Look At Travis Perkins' Liabilities

Zooming in on the latest balance sheet data, we can see that Travis Perkins had liabilities of UK£1.03b due within 12 months and liabilities of UK£1.14b due beyond that. Offsetting this, it had UK£459.8m in cash and UK£706.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£995.8m.

While this might seem like a lot, it is not so bad since Travis Perkins has a market capitalization of UK£3.00b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Travis Perkins's net debt is only 0.27 times its EBITDA. And its EBIT easily covers its interest expense, being 16.5 times the size. So we're pretty relaxed about its super-conservative use of debt. Better yet, Travis Perkins grew its EBIT by 468% last year, which is an impressive improvement. 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 ultimately the future profitability of the business will decide if Travis Perkins 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.

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 last three years, Travis Perkins actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that Travis Perkins's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Considering this range of factors, it seems to us that Travis Perkins is quite prudent with its debt, and the risks seem well managed. So we're not worried about the use of a little leverage on the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign 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.