Is Taylor Morrison Home (NYSE:TMHC) Using Too Much Debt?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Taylor Morrison Home Corporation (NYSE:TMHC) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Taylor Morrison Home

How Much Debt Does Taylor Morrison Home Carry?

As you can see below, Taylor Morrison Home had US$2.09b of debt at March 2024, down from US$2.30b a year prior. However, it also had US$554.3m in cash, and so its net debt is US$1.54b.

How Healthy Is Taylor Morrison Home's Balance Sheet?

We can see from the most recent balance sheet that Taylor Morrison Home had liabilities of US$918.5m falling due within a year, and liabilities of US$2.57b due beyond that. Offsetting this, it had US$554.3m in cash and US$189.8m in receivables that were due within 12 months. So it has liabilities totalling US$2.74b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Taylor Morrison Home is worth US$5.87b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Taylor Morrison Home has a low debt to EBITDA ratio of only 1.4. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So there's no doubt this company can take on debt while staying cool as a cucumber. The modesty of its debt load may become crucial for Taylor Morrison Home if management cannot prevent a repeat of the 25% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Taylor Morrison Home'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Taylor Morrison Home produced sturdy free cash flow equating to 63% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Neither Taylor Morrison Home's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. We think that Taylor Morrison Home's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. Given our hesitation about the stock, it would be good to know if Taylor Morrison Home insiders have sold any shares recently. You click here to find out if insiders have sold recently.

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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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.