The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Tesco PLC (LON:TSCO) does carry debt. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Tesco's Debt?
You can click the graphic below for the historical numbers, but it shows that Tesco had UK£7.27b of debt in February 2019, down from UK£8.62b, one year before. However, it does have UK£2.26b in cash offsetting this, leading to net debt of about UK£5.01b.
How Healthy Is Tesco's Balance Sheet?
The latest balance sheet data shows that Tesco had liabilities of UK£20.7b due within a year, and liabilities of UK£13.5b falling due after that. On the other hand, it had cash of UK£2.26b and UK£1.65b worth of receivables due within a year. So it has liabilities totalling UK£30.3b more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's massive market capitalization of UK£22.1b, we think shareholders really should watch Tesco's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With a debt to EBITDA ratio of 1.5, Tesco uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.7 times interest expense) certainly does not do anything to dispel this impression. Also relevant is that Tesco has grown its EBIT by a very respectable 29% in the last year, thus enhancing its ability to pay down debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Tesco can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Tesco produced sturdy free cash flow equating to 50% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Neither Tesco's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Tesco is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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.
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