Is Telecom Plus (LON:TEP) Using Too Much Debt?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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 Telecom Plus PLC (LON:TEP) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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. 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Telecom Plus

What Is Telecom Plus's Debt?

As you can see below, Telecom Plus had UK£89.4m of debt at March 2021, down from UK£94.0m a year prior. On the flip side, it has UK£25.1m in cash leading to net debt of about UK£64.3m.

How Strong Is Telecom Plus' Balance Sheet?

The latest balance sheet data shows that Telecom Plus had liabilities of UK£152.7m due within a year, and liabilities of UK£97.6m falling due after that. Offsetting these obligations, it had cash of UK£25.1m as well as receivables valued at UK£182.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£42.4m.

Of course, Telecom Plus has a market capitalization of UK£909.3m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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.

Telecom Plus has a low net debt to EBITDA ratio of only 0.99. And its EBIT easily covers its interest expense, being 20.1 times the size. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that Telecom Plus saw its EBIT decline by 8.7% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 Telecom Plus'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. During the last three years, Telecom Plus produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, Telecom Plus's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its EBIT growth rate. It's also worth noting that Telecom Plus is in the Integrated Utilities industry, which is often considered to be quite defensive. When we consider the range of factors above, it looks like Telecom Plus is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Telecom Plus is showing 2 warning signs in our investment analysis , and 1 of those shouldn't be ignored...

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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