Is Tomra Systems (OB:TOM) using too much debt?
Legendary fund manager Li Lu (whom Charlie Munger once backed) once said, “The greatest risk in investing is not price volatility, but whether you will suffer a permanent loss of capital. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We can see that Tomra Systems ASA (OB:TOM) uses debt in its business. But the real question is whether this debt makes the business risky.
What risk does debt carry?
Generally speaking, debt only becomes a real problem when a company cannot easily repay it, either by raising capital or with its own cash flow. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth 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 Tomra Systems
What is Tomra Systems’ net debt?
The image below, which you can click on for more details, shows that Tomra Systems had a debt of 1.15 billion kr at the end of September 2021, a reduction from 1.91 billion kr year-on-year. However, he has 477.3 million kr in cash to offset this, resulting in a net debt of around 676.7 million kr.
How strong is Tomra Systems’ balance sheet?
Zooming in on the latest balance sheet data, we can see that Tomra Systems had liabilities of 1.26 billion kr due within 12 months and liabilities of 4.28 billion kr due beyond. In compensation for these obligations, it had cash of 477.3 million kr as well as receivables valued at 2.79 billion kr and payable within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables of 2.27 billion kr.
Given that Tomra Systems has a market capitalization of 69.9 billion kr, it is hard to believe that these liabilities pose a threat. However, we think it’s worth keeping an eye on the strength of its balance sheet, as it can change over time. Having practically no net debt, Tomra Systems has indeed a very light debt.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Tomra Systems has net debt of just 0.35 times EBITDA, suggesting it could increase its leverage without breaking a sweat. And remarkably, although she has net debt, she has actually received more interest in the last twelve months than she has had to pay. So there’s no doubt that this company can go into debt and still be cool as a cucumber. Also positive, Tomra Systems has increased its EBIT by 26% over the past year, which should make it easier to pay down debt in the future. The balance sheet is clearly the area to focus on when analyzing debt. But it is future earnings, more than anything, that will determine Tomra Systems’ ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, while the taxman may love accounting profits, lenders only accept cash. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, Tomra Systems has produced strong free cash flow equivalent to 65% of its EBIT, which is what we expected. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
Fortunately, Tomra Systems’ impressive interest coverage means it has the upper hand on its debt. And the good news does not stop there, since its EBIT growth rate also confirms this impression! Overall, we don’t think Tomra Systems is taking bad risks, as its leverage looks modest. So we are not worried about using a little leverage on the balance sheet. There is no doubt that we learn the most about debt from the balance sheet. However, not all investment risks reside on the balance sheet, far from it. For example, we found 1 warning sign for Tomra Systems which you should be aware of before investing here.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% free, at present.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.