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Is TerraCom (ASX:TER) Using Too Much Debt?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that TerraCom Limited (ASX:TER) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for TerraCom

What Is TerraCom's Debt?

As you can see below, TerraCom had AU$36.9m of debt at June 2022, down from AU$319.8m a year prior. But on the other hand it also has AU$69.6m in cash, leading to a AU$32.7m net cash position.

debt-equity-history-analysis
debt-equity-history-analysis

How Strong Is TerraCom's Balance Sheet?

We can see from the most recent balance sheet that TerraCom had liabilities of AU$168.8m falling due within a year, and liabilities of AU$110.0m due beyond that. Offsetting these obligations, it had cash of AU$69.6m as well as receivables valued at AU$65.6m due within 12 months. So it has liabilities totalling AU$143.7m more than its cash and near-term receivables, combined.

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Since publicly traded TerraCom shares are worth a total of AU$803.5m, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, TerraCom also has more cash than debt, so we're pretty confident it can manage its debt safely.

It was also good to see that despite losing money on the EBIT line last year, TerraCom turned things around in the last 12 months, delivering and EBIT of AU$353m. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since TerraCom will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. TerraCom may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last year, TerraCom generated free cash flow amounting to a very robust 87% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Summing Up

While TerraCom does have more liabilities than liquid assets, it also has net cash of AU$32.7m. The cherry on top was that in converted 87% of that EBIT to free cash flow, bringing in AU$306m. So is TerraCom's debt a risk? It doesn't seem so to us. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that TerraCom is showing 2 warning signs in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.

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