Is Transmetro (ASX:TCO) Using Too Much Debt?

Simply Wall St

Wed, May 20, 2020, 8:25 PM 4 min read

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'. 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. We can see that Transmetro Corporation Limited (ASX:TCO) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Transmetro

What Is Transmetro's Net Debt?

As you can see below, Transmetro had AU$2.36m of debt at December 2019, down from AU$14.5m a year prior. But it also has AU$3.06m in cash to offset that, meaning it has AU$706.0k net cash.

How Strong Is Transmetro's Balance Sheet?

According to the last reported balance sheet, Transmetro had liabilities of AU$8.08m due within 12 months, and liabilities of AU$13.5m due beyond 12 months. On the other hand, it had cash of AU$3.06m and AU$1.97m worth of receivables due within a year. So its liabilities total AU$16.5m more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's AU$13.4m market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Transmetro boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

Shareholders should be aware that Transmetro's EBIT was down 95% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Transmetro's earnings that will influence how the balance sheet holds up in the future. 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. While Transmetro has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Transmetro actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

Although Transmetro's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of AU$706.0k. The cherry on top was that in converted 167% of that EBIT to free cash flow, bringing in AU$2.2m. Despite its cash we think that Transmetro seems to struggle to grow its EBIT, so we are wary of the stock. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Transmetro (at least 2 which are a bit concerning) , and understanding them should be part of your investment process.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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. 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. Thank you for reading.