Legendary fund manager Li Lu (who Charlie Munger supported) once said, “The biggest risk in investing is not price volatility, but the possibility that you will suffer a permanent loss of capital. So it can be obvious that you need to consider debt, when you think about how risky a given stock is because too much debt can sink a business. We notice that Torpol SA (WSE: TOR) has debt on its balance sheet. But should shareholders be concerned about its use of debt?
When is debt a problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, then it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are ruthlessly liquidated by their bankers. However, a more common (but still costly) event is when a company has to issue stock at bargain prices, constantly diluting shareholders, just to strengthen its balance sheet. That said, the most common situation is where a business manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash flow and debt together.
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How much debt does Torpol have?
You can click on the graph below for the historical numbers, but it shows Torpol owed Z63.9million in March 2021, up from Z69.4million a year earlier. However, his balance sheet shows that he has Z476.3million in cash, so he actually has a net cash of Z412.5million.
Is Torpol’s track record healthy?
We can see from the most recent balance sheet that Torpol had a liability of Z 681.9 million due within one year and a liability of Z 85.7 million due beyond. On the other hand, he had cash of Z 476.3 million and Z 256.9 million of receivables due within one year. It therefore has a liability totaling Z 34.4 million more than its combined cash and short-term receivables.
Considering that Torpol’s publicly traded shares are worth a total of Z357.9million, it seems unlikely that this level of liabilities is a major threat. But there are enough liabilities that we would certainly recommend that shareholders continue to monitor the balance sheet going forward. Despite her notable liabilities, Torpol has a net cash flow, so it’s fair to say that she doesn’t have a lot of debt!
On top of that, Torpol has increased its EBIT by 34% over the past twelve months, and this growth will make it easier to process its debt. The balance sheet is clearly the area you need to focus on when analyzing debt. But it is future profits, more than anything, that will determine Torpol’s ability to maintain a healthy balance sheet going forward. So if you are focused on the future you can check this out free report showing analysts’ earnings forecasts.
Finally, while the tax authorities love accounting profits, lenders only accept hard cash. While Torpol has net cash on its balance sheet, it’s still worth looking at its ability to convert earnings before interest and taxes (EBIT) into free cash flow, to help us understand how fast it’s building (or erodes) that cash balance. . Fortunately for all shareholders, Torpol has actually generated more free cash flow than EBIT over the past three years. This kind of strong cash generation warms our hearts like a puppy in a bumblebee costume.
We could understand if investors are concerned about Torpol’s liabilities, but we can take comfort in the fact that it has net cash of Z412.5million. The icing on the cake was that he converted 276% of that EBIT into free cash flow, which brought in z235 million. So is Torpol’s debt a risk? It does not seem to us. When analyzing debt levels, the balance sheet is the obvious starting point. However, not all investment risks lie on the balance sheet – far from it. We have identified 3 warning signs with Torpol (at least 1 which is significant), and understanding them should be part of your investment process.
Of course, if you are the type of investor who prefers to buy stocks without going into debt, feel free to check out our exclusive list of cash growth net stocks today.
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