These 4 Measures Indicate That Trustpower (NZSE:TPW) Is Using Debt Reasonably Well

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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?

The image below, which you can click on for greater detail, shows that at September 2020 Trustpower had debt of NZ$676.3m, up from NZ$643.5m in one year. However, because it has a cash reserve of NZ$14.3m, its net debt is less, at about NZ$662.0m.

A Look At Trustpower's Liabilities

The latest balance sheet data shows that Trustpower had liabilities of NZ$128.4m due within a year, and liabilities of NZ$946.3m falling due after that. Offsetting this, it had NZ$14.3m in cash and NZ$111.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$949.0m.

This deficit isn't so bad because Trustpower is worth NZ$2.49b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Trustpower has a debt to EBITDA ratio of 3.8 and its EBIT covered its interest expense 4.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Sadly, Trustpower's EBIT actually dropped 7.9% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Trustpower 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Trustpower recorded free cash flow worth a fulsome 87% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

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. However, our other observations weren't so heartening. For example, its net debt to EBITDA makes us a little nervous about its debt. We would also note that Electric Utilities industry companies like Trustpower commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Trustpower's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Trustpower is showing 2 warning signs in our investment analysis , and 1 of those is a bit concerning...

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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