Berkshire Hathaway’s Charlie Munger-backed external fund manager Li Lu is quick to say “The biggest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital”. So it seems like smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess the level of risk of a business. We can see that TORM plc (CPH: TRMD A) uses debt in his business. But the most important question is: what risk does this debt create?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company cannot repay it easily, either by raising capital or with its own cash flow. If things really go wrong, lenders can take over the business. However, a more common (but still painful) scenario is that he must raise new equity at low cost, thereby diluting shareholders over the long term. By replacing dilution, however, debt can be a very good tool for companies that need capital to invest in growth at high rates of return. The first step in examining a company’s debt levels is to consider its cash flow and debt together.
See our latest review for TORM
How much debt does TORM carry?
You can click on the chart below for historical numbers, but it shows TORM had $ 775.0 million in debt as of March 2021, up from $ 844.3 million a year earlier. However, he also had $ 79.6 million in cash, so his net debt is $ 695.4 million.
How healthy is TORM’s balance sheet?
The latest balance sheet data shows that TORM had liabilities of US $ 207.0 million due within one year and liabilities of US $ 788.7 million due thereafter. On the other hand, he had $ 79.6 million in cash and $ 85.9 million in receivables due within a year. Its liabilities therefore total US $ 830.2 million more than the combination of its cash and short-term receivables.
When you consider that this shortfall exceeds the company’s US $ 644.3 million market cap, you may well be inclined to take a close look at the balance sheet. Hypothetically, extremely high dilution would be required if the company were forced to repay its debts by raising capital at the current share price.
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.
While we’re not worried about TORM’s 3.8 net debt to EBITDA ratio, we do think its ultra-low 1.6x interest coverage is a sign of high leverage. It appears the company incurs significant depreciation and amortization costs, so perhaps its debt load is heavier than it first appears, since EBITDA is arguably a generous measure of profits. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. Worse yet, TORM has seen its EBIT reach 47% over the past 12 months. If profits continue to follow this path, it will be more difficult to pay off this debt than to convince us to run a marathon in the rain. When analyzing debt levels, the balance sheet is the obvious starting point. But ultimately, the company’s future profitability will decide whether TORM can strengthen its balance sheet over time. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
But our last consideration is also important, because a business cannot pay its debts with paper profits; he needs hard cash. The logical step is therefore to examine the proportion of this EBIT that corresponds to the actual free cash flow. TORM has spent a lot of money over the past three years. While investors no doubt expect this situation to reverse in due course, this clearly means its use of debt is riskier.
Our point of view
To be frank, TORM’s conversion of EBIT to free cash flow and its history of (not) growing its EBIT makes us rather uncomfortable with its debt levels. And besides, his total passive level also fails to inspire confidence. We believe that the chances of TORM having too much debt are very high. In our opinion, this means that the stock is rather risky, and probably to be avoided; but to each their own (investment) style. 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 off the balance sheet. Note that TORM displays 5 warning signs in our investment analysis , and 1 of them cannot be ignored …
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.
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