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. 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 Tattelecom Public Joint-Stock Company (MCX:TTLK) does have debt on its balance sheet. But is this debt a concern to shareholders?
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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
How Much Debt Does Tattelecom Carry?
You can click the graphic below for the historical numbers, but it shows that Tattelecom had ₽2.77b of debt in June 2019, down from ₽3.08b, one year before. However, it also had ₽571.4m in cash, and so its net debt is ₽2.20b.
How Healthy Is Tattelecom’s Balance Sheet?
According to the last reported balance sheet, Tattelecom had liabilities of ₽2.49b due within 12 months, and liabilities of ₽3.97b due beyond 12 months. On the other hand, it had cash of ₽571.4m and ₽1.37b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₽4.52b.
Given this deficit is actually higher than the company’s market capitalization of ₽3.88b, we think shareholders really should watch Tattelecom’s debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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).
While Tattelecom’s low debt to EBITDA ratio of 0.86 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.9 last year does give us pause. So we’d recommend keeping a close eye on the impact financing costs are having on the business. It is well worth noting that Tattelecom’s EBIT shot up like bamboo after rain, gaining 47% in the last twelve months. That’ll make it easier to manage its debt. There’s no doubt that we learn most about debt from the balance sheet. But it is Tattelecom’s earnings that will influence how the balance sheet holds up in the future. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Tattelecom recorded free cash flow worth a fulsome 85% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
The good news is that Tattelecom’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But we must concede we find its level of total liabilities has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Tattelecom can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it’s worth keeping an eye on this one. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Tattelecom’s dividend history, without delay!
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.
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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.