Telecom Italia (BIT:TIT) Seems To Be Using A Lot Of 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.' 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. Importantly, Telecom Italia S.p.A. (BIT:TIT) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

See our latest analysis for Telecom Italia

What Is Telecom Italia's Net Debt?

The chart below, which you can click on for greater detail, shows that Telecom Italia had €27.5b in debt in September 2023; about the same as the year before. However, because it has a cash reserve of €5.11b, its net debt is less, at about €22.4b.

How Strong Is Telecom Italia's Balance Sheet?

We can see from the most recent balance sheet that Telecom Italia had liabilities of €14.9b falling due within a year, and liabilities of €28.9b due beyond that. Offsetting this, it had €5.11b in cash and €5.00b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €33.7b.

This deficit casts a shadow over the €5.72b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Telecom Italia would likely require a major re-capitalisation if it had to pay its creditors today.

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.

While Telecom Italia's debt to EBITDA ratio (4.3) suggests that it uses some debt, its interest cover is very weak, at 0.73, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Notably, Telecom Italia's EBIT was pretty flat over the last year, which isn't ideal given the debt load. 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 Italia'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Telecom Italia burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Telecom Italia's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. After considering the datapoints discussed, we think Telecom Italia has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. While Telecom Italia didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.

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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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.