Is Telkom SA SOC (JSE:TKG) A Risky Investment?

Warren Buffett famously said, '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. We note that Telkom SA SOC Limited (JSE:TKG) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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.

See our latest analysis for Telkom SA SOC

What Is Telkom SA SOC's Debt?

You can click the graphic below for the historical numbers, but it shows that Telkom SA SOC had R11.2b of debt in September 2020, down from R13.0b, one year before. However, because it has a cash reserve of R4.23b, its net debt is less, at about R6.98b.

A Look At Telkom SA SOC's Liabilities

Zooming in on the latest balance sheet data, we can see that Telkom SA SOC had liabilities of R15.9b due within 12 months and liabilities of R15.7b due beyond that. Offsetting this, it had R4.23b in cash and R7.35b in receivables that were due within 12 months. So it has liabilities totalling R20.1b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of R20.0b, we think shareholders really should watch Telkom SA SOC's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Telkom SA SOC's low debt to EBITDA ratio of 0.72 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.8 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Importantly Telkom SA SOC's EBIT was essentially flat over the last twelve months. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Telkom SA SOC'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.

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. Looking at the most recent three years, Telkom SA SOC recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Telkom SA SOC's level of total liabilities and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its net debt to EBITDA tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Telkom SA SOC's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 3 warning signs for Telkom SA SOC you should be aware of.

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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