Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that TE Connectivity Ltd. (NYSE:TEL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.
What Is TE Connectivity's Debt?
As you can see below, TE Connectivity had US$4.07b of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it also had US$546.0m in cash, and so its net debt is US$3.53b.
How Strong Is TE Connectivity's Balance Sheet?
The latest balance sheet data shows that TE Connectivity had liabilities of US$3.69b due within a year, and liabilities of US$5.43b falling due after that. Offsetting this, it had US$546.0m in cash and US$2.46b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$6.12b.
Since publicly traded TE Connectivity shares are worth a very impressive total of US$32.5b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
TE Connectivity's net debt is only 1.2 times its EBITDA. And its EBIT easily covers its interest expense, being 35.9 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, TE Connectivity grew its EBIT by 3.3% in the last year, making that debt load look even more manageable. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine TE Connectivity's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, TE Connectivity produced sturdy free cash flow equating to 68% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Happily, TE Connectivity's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. When we consider the range of factors above, it looks like TE Connectivity is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. We'd be motivated to research the stock further if we found out that TE Connectivity insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.