Is Twin Disc (NASDAQ:TWIN) Using Debt Sensibly?

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.' 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. As with many other companies Twin Disc, Incorporated (NASDAQ:TWIN) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Twin Disc

What Is Twin Disc's Debt?

As you can see below, Twin Disc had US$44.1m of debt at September 2020, down from US$50.4m a year prior. However, it does have US$9.31m in cash offsetting this, leading to net debt of about US$34.7m.

How Strong Is Twin Disc's Balance Sheet?

According to the last reported balance sheet, Twin Disc had liabilities of US$69.4m due within 12 months, and liabilities of US$92.4m due beyond 12 months. Offsetting these obligations, it had cash of US$9.31m as well as receivables valued at US$31.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$120.7m.

When you consider that this deficiency exceeds the company's US$102.4m market capitalization, you might well be inclined to review the balance sheet intently. 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. 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 Twin Disc 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.

Over 12 months, Twin Disc made a loss at the EBIT level, and saw its revenue drop to US$234m, which is a fall of 19%. We would much prefer see growth.

Caveat Emptor

While Twin Disc's falling revenue is about as heartwarming as a wet blanket, arguably its earnings before interest and tax (EBIT) loss is even less appealing. Indeed, it lost US$2.4m at the EBIT level. When we look at that alongside the significant liabilities, we're not particularly confident about the company. We'd want to see some strong near-term improvements before getting too interested in the stock. Not least because it had negative free cash flow of US$1.2m over the last twelve months. So suffice it to say we consider the stock to be risky. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 2 warning signs with Twin Disc , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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