Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 Tetra Tech, Inc. (NASDAQ:TTEK) 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. If things get really bad, the lenders can take control of the business. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Tetra Tech’s Debt?
As you can see below, Tetra Tech had US$221.9m of debt at October 2021, down from US$307.2m a year prior. However, it also had US$166.6m in cash, and so its net debt is US$55.3m.
How Healthy Is Tetra Tech’s Balance Sheet?
We can see from the most recent balance sheet that Tetra Tech had liabilities of US$848.5m falling due within a year, and liabilities of US$493.8m due beyond that. On the other hand, it had cash of US$166.6m and US$787.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$388.7m.
Given Tetra Tech has a market capitalization of US$7.77b, it’s hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Carrying virtually no net debt, Tetra Tech has a very light debt load indeed.
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). 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).
Tetra Tech has a low net debt to EBITDA ratio of only 0.18. And its EBIT easily covers its interest expense, being 23.4 times the size. So we’re pretty relaxed about its super-conservative use of debt. And we also note warmly that Tetra Tech grew its EBIT by 13% last year, making its debt load easier to handle. 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 Tetra Tech can strengthen its balance sheet over time.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Tetra Tech 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
Happily, Tetra Tech’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. Considering this range of factors, it seems to us that Tetra Tech is quite prudent with its debt, and the risks seem well managed. So the balance sheet looks pretty healthy, to us. When analysing debt levels, the balance sheet is the obvious place to start.