Berkshire Hathaway’s Charlie Munger-backed outside fund manager Li Lu is quick to say, “The biggest risk in investing isn’t price volatility, but whether you’re going to suffer a permanent loss of capital “. So it seems smart money knows that debt – which is usually involved in bankruptcies – is a very important factor when you’re assessing a company’s risk. We note that Titan Machinery Inc. (NASDAQ:TITN) has debt on its balance sheet. But the more important question is: what risk does this debt create?
When is debt dangerous?
Debt and other liabilities become risky for a business when it cannot easily meet those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case, 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 at a low price, thereby permanently diluting shareholders. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. The first step when considering a company’s debt levels is to consider its cash and debt together.
What is Titan Machinery’s debt?
As you can see below, at the end of July 2022, Titan Machinery had $355.6 million in debt, up from $238.8 million a year ago. Click on the image for more details. However, since he has a cash reserve of $142.1 million, his net debt is less, at around $213.5 million.
A Look at Titan Machinery’s Responsibilities
Zooming in on the latest balance sheet data, we can see that Titan Machinery had liabilities of US$459.7 million due within 12 months and liabilities of US$143.9 million due beyond. On the other hand, it had a cash position of 142.1 million dollars and 96.4 million dollars of receivables at less than one year. Thus, its liabilities outweigh the sum of its cash and receivables (current) by $365.2 million.
Titan Machinery has a market capitalization of $682.3 million, so it could very likely raise funds to improve its balance sheet, should the need arise. However, it is always worth taking a close look at its ability to repay debt.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
We would say that Titan Machinery’s moderate net debt to EBITDA ratio (1.5) indicates caution in leverage. And its strong interest coverage of 22.0 times makes us even more comfortable. Even better, Titan Machinery increased its EBIT by 102% last year, which is an impressive improvement. This boost will make it even easier to pay off debt in the future. There is no doubt that we learn the most about debt from the balance sheet. But ultimately, the company’s future profitability will decide whether Titan Machinery can strengthen its balance sheet over time. So if you want to see what the pros think, you might find this free analyst earnings forecast report Be interesting.
Finally, while the taxman may love accounting profits, lenders only accept cash. We therefore always check how much of this EBIT is converted into free cash flow. Over the past three years, Titan Machinery has actually produced more free cash flow than EBIT. There’s nothing better than incoming money to stay in the good books of your lenders.
Our point of view
The good news is that Titan Machinery’s demonstrated ability to cover its interest costs with its EBIT delights us like a fluffy puppy does a toddler. But truth be told, we think his total passive level undermines that impression a bit. Zooming out, Titan Machinery seems to be using debt quite sensibly; and that gets the green light from us. Although debt carries risks, when used wisely, it can also generate a higher return on equity. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example, Titan Machinery has 2 warning signs (and 1 that should not be overlooked) we think you should know.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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