Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Like many other companies TT limited (NSE:TTL) uses debt. But the real question is whether this debt makes the business risky.
When is debt a problem?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. If things go really bad, lenders can take over the business. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. 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.
See our latest analysis for TT
What is TT’s debt?
As you can see below, TT had a debt of ₹2.37 billion in September 2021, up from ₹2.62 billion in the previous year. And he doesn’t have a lot of cash, so his net debt is about the same.
How strong is TT’s balance sheet?
The latest balance sheet data shows that TT had liabilities of ₹1.55 billion due within a year, and liabilities of ₹1.25 billion falling due thereafter. On the other hand, it had cash of ₹25.3 million and ₹619.3 million in receivables due within one year. It therefore has liabilities totaling ₹2.16 billion more than its cash and short-term receivables, combined.
This is a mountain of leverage compared to its market capitalization of ₹2.35 billion. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant dilution.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). Thus, we consider debt to earnings with and without amortization and depreciation expense.
While we’re not concerned about TT’s net debt to EBITDA ratio of 4.1, we believe its extremely low interest coverage of 1.8x is a sign of high leverage. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. The silver lining is that TT increased its EBIT by 121% last year, which feeds like youthful idealism. If this earnings trend continues, it will make its leverage much more manageable in the future. When analyzing debt levels, the balance sheet is the obvious starting point. But you can’t look at debt in total isolation; since TT will need income to repay this debt. So, if you want to know more about its earnings, it may be worth checking out this graph of its long-term trend.
Finally, a company can only repay its debts with cold hard cash, not with book profits. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, TT has actually produced more free cash flow than EBIT. There’s nothing better than cash coming in to stay in your lenders’ good books.
Our point of view
TT’s EBIT to free cash flow conversion was a real benefit in this analysis, as was its EBIT growth rate. On the other hand, our confidence was shaken by its apparent struggle to cover its interest charges with its EBIT. When we consider all the factors mentioned above, we feel a bit cautious about TT’s use of debt. While we understand that debt can improve returns on equity, we suggest shareholders keep a close eye on their level of debt, lest it increase. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. For example, we found 5 warning signs for the TT (1 cannot be ignored!) which you should be aware of before investing here.
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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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.