Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 TT Electronics plc (LON:TTG) 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. If things get really bad, the lenders can take control of the business. 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.
What Is TT Electronics's Debt?
As you can see below, at the end of December 2020, TT Electronics had UK£138.2m of debt, up from UK£121.3m a year ago. Click the image for more detail. On the flip side, it has UK£70.2m in cash leading to net debt of about UK£68.0m.
How Strong Is TT Electronics' Balance Sheet?
We can see from the most recent balance sheet that TT Electronics had liabilities of UK£111.3m falling due within a year, and liabilities of UK£163.5m due beyond that. On the other hand, it had cash of UK£70.2m and UK£68.6m worth of receivables due within a year. So its liabilities total UK£136.0m more than the combination of its cash and short-term receivables.
TT Electronics has a market capitalization of UK£406.1m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While TT Electronics's debt to EBITDA ratio (3.4) suggests that it uses some debt, its interest cover is very weak, at 1.7, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Even worse, TT Electronics saw its EBIT tank 60% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if TT Electronics 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. During the last three years, TT Electronics generated free cash flow amounting to a very robust 92% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
TT Electronics's EBIT growth rate and interest cover definitely weigh on it, in our esteem. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that TT Electronics 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. 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. Be aware that TT Electronics is showing 4 warning signs in our investment analysis , and 1 of those is significant...
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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TT Electronics plc provides engineered electronics for performance critical applications in the automation and electrification, healthcare, and aerospace and defense markets worldwide.
Adequate balance sheet with acceptable track record.