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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Transtema Group AB (STO:TRANS) does carry debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Transtema Group's Net Debt?
As you can see below, Transtema Group had kr95.9m of debt at September 2020, down from kr164.7m a year prior. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Transtema Group's Balance Sheet?
The latest balance sheet data shows that Transtema Group had liabilities of kr404.6m due within a year, and liabilities of kr104.1m falling due after that. On the other hand, it had cash of kr1.84m and kr127.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by kr379.7m.
This is a mountain of leverage relative to its market capitalization of kr525.3m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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 sitting at just 0.65 times EBITDA, Transtema Group is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.6 times the interest expense over the last year. In fact Transtema Group's saving grace is its low debt levels, because its EBIT has tanked 29% in the last twelve months. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Transtema Group'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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last two years, Transtema Group actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Neither Transtema Group's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. Looking at all the angles mentioned above, it does seem to us that Transtema Group is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example - Transtema Group has 5 warning signs we think you should be aware of.
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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