These 4 Measures Indicate That Port of Tauranga (NZSE:POT) Is Using Debt Reasonably Well

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. We note that Port of Tauranga Limited (NZSE:POT) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Port of Tauranga

How Much Debt Does Port of Tauranga Carry?

As you can see below, at the end of June 2020, Port of Tauranga had NZ$517.8m of debt, up from NZ$468.0m a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.

How Strong Is Port of Tauranga's Balance Sheet?

We can see from the most recent balance sheet that Port of Tauranga had liabilities of NZ$301.5m falling due within a year, and liabilities of NZ$352.1m due beyond that. Offsetting this, it had NZ$8.57m in cash and NZ$44.2m in receivables that were due within 12 months. So it has liabilities totalling NZ$600.9m more than its cash and near-term receivables, combined.

Given Port of Tauranga has a market capitalization of NZ$5.00b, 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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 3.2 Port of Tauranga has a fairly noticeable amount of debt. On the plus side, its EBIT was 7.2 times its interest expense, and its net debt to EBITDA, was quite high, at 3.2. Sadly, Port of Tauranga's EBIT actually dropped 9.0% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Port of Tauranga recorded free cash flow worth 56% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

We weren't impressed with Port of Tauranga's net debt to EBITDA, and its EBIT growth rate made us cautious. On the other hand, we found comfort in its relatively strong conversion of EBIT to free cash flow. We would also note that Infrastructure industry companies like Port of Tauranga commonly do use debt without problems. Considering this range of data points, we think Port of Tauranga is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Consider risks, for instance. Every company has them, and we've spotted 2 warning signs for Port of Tauranga you should know about.

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.

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