Tesco (LON:TSCO) Takes On Some Risk With Its Use Of Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Tesco PLC (LON:TSCO) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Tesco

What Is Tesco's Debt?

The image below, which you can click on for greater detail, shows that at August 2020 Tesco had debt of UK£7.82b, up from UK£6.92b in one year. However, because it has a cash reserve of UK£2.57b, its net debt is less, at about UK£5.25b.

A Look At Tesco's Liabilities

We can see from the most recent balance sheet that Tesco had liabilities of UK£18.5b falling due within a year, and liabilities of UK£21.5b due beyond that. Offsetting these obligations, it had cash of UK£2.57b as well as receivables valued at UK£1.47b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£35.9b.

The deficiency here weighs heavily on the UK£22.1b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Tesco would probably need a major re-capitalization if its creditors were to demand repayment.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Looking at its net debt to EBITDA of 1.3 and interest cover of 3.9 times, it seems to us that Tesco 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. We saw Tesco grow its EBIT by 6.3% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Tesco can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Tesco recorded free cash flow of 25% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Tesco's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But on the bright side, its net debt to EBITDA is a good sign, and makes us more optimistic. Overall, it seems to us that Tesco's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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. Be aware that Tesco is showing 3 warning signs in our investment analysis , and 1 of those is a bit concerning...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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