David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Titan Machinery Inc. (NASDAQ:TITN) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

What Is Titan Machinery’s Debt?

The image below, which you can click on for greater detail, shows that Titan Machinery had debt of US$238.8m at the end of July 2021, a reduction from US$387.6m over a year. However, it also had US$65.6m in cash, and so its net debt is US$173.2m.

How Healthy Is Titan Machinery’s Balance Sheet?

The latest balance sheet data shows that Titan Machinery had liabilities of US$310.5m due within a year, and liabilities of US$137.0m falling due after that. Offsetting these obligations, it had cash of US$65.6m as well as receivables valued at US$82.1m due within 12 months. So its liabilities total US$299.9m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Titan Machinery has a market capitalization of US$575.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Titan Machinery’s net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its commanding EBIT of 11.5 times its interest expense, implies the debt load is as light as a peacock feather. It is well worth noting that Titan Machinery’s EBIT shot up like bamboo after rain, gaining 97% in the last twelve months. That’ll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Titan Machinery 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Titan Machinery actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

The good news is that Titan Machinery’s demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. Looking at the bigger picture, we think Titan Machinery’s use of debt seems quite reasonable and we’re not concerned about it. After all, sensible leverage can boost returns on equity.