Transcontinental Realty Investors (NYSE:TCI) Takes On Some Risk With Its Use Of Debt

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.' 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 Transcontinental Realty Investors, Inc. (NYSE:TCI) makes use of debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Transcontinental Realty Investors

What Is Transcontinental Realty Investors's Debt?

The image below, which you can click on for greater detail, shows that Transcontinental Realty Investors had debt of US$426.2m at the end of March 2021, a reduction from US$460.5m over a year. However, it also had US$53.9m in cash, and so its net debt is US$372.3m.

A Look At Transcontinental Realty Investors' Liabilities

We can see from the most recent balance sheet that Transcontinental Realty Investors had liabilities of US$26.3m falling due within a year, and liabilities of US$426.8m due beyond that. On the other hand, it had cash of US$53.9m and US$157.4m worth of receivables due within a year. So it has liabilities totalling US$241.8m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of US$261.9m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Transcontinental Realty Investors shareholders face the double whammy of a high net debt to EBITDA ratio (16.7), and fairly weak interest coverage, since EBIT is just 0.45 times the interest expense. This means we'd consider it to have a heavy debt load. However, the silver lining was that Transcontinental Realty Investors achieved a positive EBIT of US$4.1m in the last twelve months, an improvement on the prior year's loss. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Transcontinental Realty Investors will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, Transcontinental Realty Investors actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Neither Transcontinental Realty Investors's ability to cover its interest expense with its EBIT nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Transcontinental Realty Investors's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. To that end, you should learn about the 3 warning signs we've spotted with Transcontinental Realty Investors (including 1 which can't be ignored) .

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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