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.' 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 Port of Tauranga Limited (NZSE:POT) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Port of Tauranga's Debt?
As you can see below, Port of Tauranga had NZ$540.0m of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. Net debt is about the same, since the it doesn't have much cash.
How Strong Is Port of Tauranga's Balance Sheet?
According to the last reported balance sheet, Port of Tauranga had liabilities of NZ$389.9m due within 12 months, and liabilities of NZ$297.0m due beyond 12 months. Offsetting this, it had NZ$9.93m in cash and NZ$56.5m in receivables that were due within 12 months. So its liabilities total NZ$620.5m more than the combination of its cash and short-term receivables.
Given Port of Tauranga has a market capitalization of NZ$5.08b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With net debt to EBITDA of 3.3 Port of Tauranga has a fairly noticeable amount of debt. But the high interest coverage of 7.6 suggests it can easily service that debt. Unfortunately, Port of Tauranga saw its EBIT slide 8.5% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 Port of Tauranga 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.
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. Looking at the most recent three years, Port of Tauranga recorded free cash flow of 50% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
We weren't impressed with Port of Tauranga's net debt to EBITDA, and its EBIT growth rate made us cautious. Balancing that a bit, it has a demonstrated ability interest cover. It's also worth noting that Port of Tauranga is in the Infrastructure industry, which is often considered to be quite defensive. Looking at all this data makes us feel a little cautious about Port of Tauranga's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Port of Tauranga you should know about.
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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