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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.' 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. We note that Torchmark Corporation (NYSE:TMK) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
View our latest analysis for Torchmark
What Is Torchmark's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Torchmark had US$1.65b of debt, an increase on US$1.50b, over one year. However, it also had US$193.1m in cash, and so its net debt is US$1.46b.
How Healthy Is Torchmark's Balance Sheet?
We can see from the most recent balance sheet that Torchmark had liabilities of US$2.00b falling due within a year, and liabilities of US$16.1b due beyond that. On the other hand, it had cash of US$193.1m and US$419.6m worth of receivables due within a year. So it has liabilities totalling US$17.5b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the US$9.72b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt At the end of the day, Torchmark would probably need a major re-capitalization if its creditors were to demand repayment. Because it carries more debt than cash, we think it's worth watching Torchmark's balance sheet 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). 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).
Torchmark has a low net debt to EBITDA ratio of only 1.48. And its EBIT easily covers its interest expense, being 10.8 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. We saw Torchmark grow its EBIT by 3.4% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Torchmark's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Torchmark actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Our View
We feel some trepidation about Torchmark's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its conversion of EBIT to free cash flow and interest cover give us some confidence in its ability to manage its debt. Looking at all the angles mentioned above, it does seem to us that Torchmark is a somewhat risky investment as a result of its debt. 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 Torchmark insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.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. Thank you for reading.