Is Trustpower (NZSE:TPW) A Risky Investment?

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 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 Trustpower Limited (NZSE:TPW) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Trustpower

What Is Trustpower's Net Debt?

As you can see below, at the end of March 2021, Trustpower had NZ$755.9m of debt, up from NZ$653.2m a year ago. Click the image for more detail. And it doesn't have much cash, so its net debt is about the same.

A Look At Trustpower's Liabilities

We can see from the most recent balance sheet that Trustpower had liabilities of NZ$317.6m falling due within a year, and liabilities of NZ$937.9m due beyond that. Offsetting these obligations, it had cash of NZ$6.09m as well as receivables valued at NZ$125.1m due within 12 months. So its liabilities total NZ$1.12b more than the combination of its cash and short-term receivables.

Trustpower has a market capitalization of NZ$2.29b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Trustpower has a debt to EBITDA ratio of 4.2 and its EBIT covered its interest expense 5.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We saw Trustpower grow its EBIT by 7.7% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. 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 Trustpower'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Trustpower produced sturdy free cash flow equating to 76% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

When it comes to the balance sheet, the standout positive for Trustpower was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit handle its debt, based on its EBITDA,. We would also note that Electric Utilities industry companies like Trustpower commonly do use debt without problems. When we consider all the elements mentioned above, it seems to us that Trustpower is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. For example, we've discovered 4 warning signs for Trustpower (1 can't be ignored!) that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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.

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