Is TerraForm Power (NASDAQ:TERP) Using Too Much Debt?

Source:-simplywall.st

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, ‘The possibility of permanent loss is the risk I worry about… and every practical investor I know worries about.’ 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 TerraForm Power, Inc. (NASDAQ:TERP) makes use of debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for TerraForm Power

What Is TerraForm Power’s Debt?

As you can see below, at the end of March 2020, TerraForm Power had US$6.99b of debt, up from US$5.68b a year ago. Click the image for more detail. However, it also had US$249.2m in cash, and so its net debt is US$6.74b.

debt-equity-history-analysis
NasdaqGS:TERP Debt to Equity History July 28th 2020
A Look At TerraForm Power’s Liabilities
According to the last reported balance sheet, TerraForm Power had liabilities of US$740.9m due within 12 months, and liabilities of US$7.43b due beyond 12 months. On the other hand, it had cash of US$249.2m and US$190.7m worth of receivables due within a year. So its liabilities total US$7.7b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the US$4.54b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, TerraForm Power would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). 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).

TerraForm Power shareholders face the double whammy of a high net debt to EBITDA ratio (10.9), and fairly weak interest coverage, since EBIT is just 0.45 times the interest expense. This means we’d consider it to have a heavy debt load. Even more troubling is the fact that TerraForm Power actually let its EBIT decrease by 4.7% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill — a lot of effort for not much advancement. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine TerraForm Power’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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, TerraForm Power actually produced more free cash flow than EBIT. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.

Our View
To be frank both TerraForm Power’s interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Overall, it seems to us that TerraForm Power’s balance sheet is really quite a risk to the business. So we’re almost as wary of this stock as a hungry kitten is about falling into its owner’s fish pond: once bitten, twice shy, as they say. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 3 warning signs we’ve spotted with TerraForm Power .

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.
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