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. So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that Telecom Plus PLC (LON:TEP) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Telecom Plus's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 Telecom Plus had debt of UK£69.7m, up from UK£49.7m in one year. However, because it has a cash reserve of UK£35.6m, its net debt is less, at about UK£34.1m.
How Strong Is Telecom Plus's Balance Sheet?
According to the last reported balance sheet, Telecom Plus had liabilities of UK£112.7m due within 12 months, and liabilities of UK£77.2m due beyond 12 months. Offsetting this, it had UK£35.6m in cash and UK£48.1m in receivables that were due within 12 months. So its liabilities total UK£106.2m more than the combination of its cash and short-term receivables.
Since publicly traded Telecom Plus shares are worth a total of UK£1.05b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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's net debt is only 0.56 times its EBITDA. And its EBIT covers its interest expense a whopping 29.7 times over. So we're pretty relaxed about its super-conservative use of debt. The good news is that Telecom Plus has increased its EBIT by 9.5% over twelve months, which should ease any concerns about debt repayment. When analysing debt levels, the balance sheet is the obvious place to start. 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 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Telecom Plus recorded free cash flow worth 77% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Happily, Telecom Plus's impressive interest cover implies it has the upper hand on its debt. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! It's also worth noting that Telecom Plus is in the Integrated Utilities industry, which is often considered to be quite defensive. Considering this range of factors, it seems to us that Telecom Plus 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. Given Telecom Plus has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
If you spot an error that warrants correction, please contact the editor at email@example.com. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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