Telkom SA SOC (JSE:TKG) Has A Somewhat Strained Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Telkom SA SOC Limited (JSE:TKG) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Telkom SA SOC

What Is Telkom SA SOC's Net Debt?

As you can see below, at the end of March 2022, Telkom SA SOC had R12.4b of debt, up from R11.4b a year ago. Click the image for more detail. However, because it has a cash reserve of R3.30b, its net debt is less, at about R9.06b.

How Strong Is Telkom SA SOC's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Telkom SA SOC had liabilities of R18.6b due within 12 months and liabilities of R13.4b due beyond that. Offsetting these obligations, it had cash of R3.30b as well as receivables valued at R9.45b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R19.2b.

This deficit is considerable relative to its market capitalization of R20.1b, so it does suggest shareholders should keep an eye on Telkom SA SOC's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Telkom SA SOC has net debt of just 0.90 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 8.1 times the interest expense over the last year. But the other side of the story is that Telkom SA SOC saw its EBIT decline by 4.7% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. 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 Telkom SA SOC'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, 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. Looking at the most recent three years, Telkom SA SOC recorded free cash flow of 40% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

While Telkom SA SOC's level of total liabilities does give us pause, its net debt to EBITDA and interest cover suggest it can stay on top of its debt load. When we consider all the factors discussed, it seems to us that Telkom SA SOC is taking some risks with its use of debt. 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. For example - Telkom SA SOC has 1 warning sign we think you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.