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.’ 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 can see that Tesla, Inc. (NASDAQ:TSLA) does use debt in its business. But the more important question is: how much risk is that debt creating?
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.
What Is Tesla’s Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 Tesla had US$12.7b of debt, an increase on US$11.4b, over one year. However, because it has a cash reserve of US$8.62b, its net debt is less, at about US$4.08b.
How Healthy Is Tesla’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Tesla had liabilities of US$12.3b due within 12 months and liabilities of US$14.5b due beyond that. Offsetting these obligations, it had cash of US$8.62b as well as receivables valued at US$1.50b due within 12 months. So its liabilities total US$16.7b more than the combination of its cash and short-term receivables.
Given Tesla has a humongous market capitalization of US$264.4b, it’s hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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.
Given net debt is only 1.2 times EBITDA, it is initially surprising to see that Tesla’s EBIT has low interest coverage of 1.8 times. So while we’re not necessarily alarmed we think that its debt is far from trivial. Pleasingly, Tesla is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 267% gain in the last twelve months. 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 Tesla 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 business needs free cash flow to pay off debt; accounting profits just don’t cut it. So it’s worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Tesla actually produced more free cash flow than EBIT over the last two years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Happily, Tesla’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But the stark truth is that we are concerned by its interest cover. Zooming out, Tesla seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we’ve discovered 3 warning signs for Tesla (1 makes us a bit uncomfortable!) that you should be aware of before investing here.
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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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. 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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