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. We notice that Telecom Plus Plc (LON:TEP) has debt on its balance sheet. But should shareholders worry about its use of debt?
Why is debt risky?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
Discover our latest analysis for Telecom Plus
What is Telecom Plus’ net debt?
You can click on the chart below for historical figures, but it shows that in September 2021 Telecom Plus had a debt of £94.6m, up from £79.2m , over one year. However, he also had £23.2m in cash, so his net debt is £71.4m.
A look at the responsibilities of Telecom Plus
Zooming in on the latest balance sheet data, we can see that Telecom Plus had liabilities of £114.8m due within 12 months and liabilities of £102.7m due beyond. As compensation for these obligations, it had cash of £23.2 million as well as receivables valued at £145.4 million due within 12 months. It therefore has liabilities totaling £49.0 million more than its cash and short-term receivables, combined.
Given that Telecom Plus has a market capitalization of £1.17 billion, it’s hard to believe that these liabilities pose a threat. However, we think it’s worth keeping an eye on the strength of its balance sheet, as it can change over time.
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). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
Telecom Plus has a low net debt to EBITDA ratio of just 1.2. And its EBIT easily covers its interest costs, which is 23.8 times the size. So we’re pretty relaxed about his super conservative use of debt. But the bad news is that Telecom Plus has seen its EBIT plunge by 11% over the last twelve months. If this rate of decline in profits continues, the company could find itself in a difficult situation. There is no doubt that we learn the most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Telecom Plus’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, Telecom Plus has produced strong free cash flow equivalent to 55% of its EBIT, which is what we expected. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
Fortunately, Telecom Plus’ impressive interest coverage means it has the upper hand on its debt. But we have to admit that we are seeing its EBIT growth rate having the opposite effect. It should also be noted that Telecom Plus belongs to the integrated utility sector, which is often considered quite defensive. Looking at all of the aforementioned factors together, it seems to us that Telecom Plus can manage its debt quite comfortably. Of course, while this leverage can improve return on equity, it comes with more risk, so it’s worth keeping an eye out for. 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 outside of the balance sheet. We have identified 2 warning signs with Telecom Plus, and understanding them should be part of your investment process.
If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
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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.