Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk’. 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. As with many other companies Tetra Tech, Inc. (NASDAQ:TTEK) makes use of debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Tetra Tech’s Net Debt?
The image below, which you can click on for greater detail, shows that at December 2019 Tetra Tech had debt of US$344.2m, up from US$263.0m in one year. On the flip side, it has US$110.8m in cash leading to net debt of about US$233.4m.
How Strong Is Tetra Tech’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Tetra Tech had liabilities of US$712.5m due within 12 months and liabilities of US$613.3m due beyond that. Offsetting these obligations, it had cash of US$110.8m as well as receivables valued at US$856.7m due within 12 months. So its liabilities total US$358.2m more than the combination of its cash and short-term receivables.
Since publicly traded Tetra Tech shares are worth a total of US$5.20b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).
Tetra Tech’s net debt is only 0.96 times its EBITDA. And its EBIT easily covers its interest expense, being 15.3 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. The good news is that Tetra Tech has increased its EBIT by 4.5% over twelve months, which should ease any concerns about debt repayment. 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 Tetra Tech can strengthen its balance sheet over time. 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 it’s worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Tetra Tech recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
Happily, Tetra Tech’s impressive interest cover implies it has the upper hand on its debt. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Looking at the bigger picture, we think Tetra Tech’s use of debt seems quite reasonable and we’re not concerned about it. After all, sensible leverage can boost returns on equity. Of course, we wouldn’t say no to the extra confidence that we’d gain if we knew that Tetra Tech insiders have been buying shares: if you’re on the same wavelength, you can find out if insiders are buying by clicking this link.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.
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