Howard Marks put it well when he said that, rather than worrying about stock price volatility, “The possibility of permanent loss is the risk I worry about … and every investor practice that I know is worried. ” So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. We note that Limited trust power (NZSE: TPW) has debt on its balance sheet. But should shareholders be concerned about its use of debt?
What risk does debt entail?
Debt helps a business until the business struggles to repay it, either with new capital or with free cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) situation is where a company has to dilute its shareholders at a cheap share price just to get its debt under control. Of course, debt can be an important tool in businesses, especially capital intensive businesses. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
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What is Trustpower’s net debt?
As you can see below, at the end of March 2021, Trustpower was in debt of NZ $ 755.9 million, up from NZ $ 653.2 million a year ago. Click on the image for more details. And he doesn’t have a lot of cash, so his net debt is about the same.
A look at the responsibilities of Trustpower
We can see from the most recent balance sheet that Trustpower had liabilities of NZ $ 317.6 million maturing within one year and liabilities of NZ $ 937.9 million owed to it. of the. In compensation for these obligations, it had cash of NZ $ 6.09 million as well as receivables valued at NZ $ 125.1 million due within 12 months. Its liabilities therefore total NZ $ 1.12 billion more than the combination of its cash and short-term receivables.
Trustpower has a market capitalization of NZ $ 2.29 billion, so it could most likely raise funds to improve its balance sheet, should the need arise. But we absolutely want to keep our eyes open for indications that its debt is too risky.
In order to measure a company’s debt relative to its profits, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its profit before interest and taxes (EBIT) divided by its interest. debtors (its interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Trustpower has a debt to EBITDA ratio of 4.2 and its EBIT covered its interest expense 5.7 times. Overall, this implies that while we wouldn’t like to see debt levels rise, we believe it can handle its current leverage. We have seen Trustpower increase its EBIT by 7.7% over the past twelve months. It’s far from incredible, but it’s a good thing when it comes to paying down debt. The balance sheet is clearly the area to focus on when analyzing debt. But it is future profits, more than anything, that will determine Trustpower’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, a business needs free cash flow to pay off debts; accounting profits are not enough. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. Over the past three years, Trustpower has generated strong free cash flow equivalent to 76% of its EBIT, roughly what we expected. This hard cash allows him to reduce his debt whenever he wants.
Our point of view
On the balance sheet, the bright spot for Trustpower was the fact that it appears to be able to convert EBIT to free cash flow with confidence. But the other factors we noted above weren’t so encouraging. For example, it looks like he’s having a little trouble managing his debt, based on his EBITDA. We would also like to note that electric utility companies like Trustpower generally use debt with no problem. When we consider all the elements mentioned above, it seems to us that Trustpower is managing its debt quite well. That said, the load is heavy enough that we recommend that any shareholder watch it closely. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist off the balance sheet. For example, we discovered 4 warning signs for Trustpower (1 cannot be ignored!) Which you should be aware of before investing here.
At the end of the day, it’s often best to focus on businesses with no net debt. You can access our special list of these companies (all with a history of profit growth). It’s free.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts using only unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell shares and does not take into account your goals or your financial situation. Our aim is to bring you long-term, targeted analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price sensitive companies or qualitative material. Simply Wall St has no position in the mentioned stocks.
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