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.' 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 note that Tractor Supply Company (NASDAQ:TSCO) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

What Is Tractor Supply's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Tractor Supply had US$1.73b of debt, an increase on US$1.60b, over one year. However, because it has a cash reserve of US$264.1m, its net debt is less, at about US$1.47b.

How Strong Is Tractor Supply's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Tractor Supply had liabilities of US$2.52b due within 12 months and liabilities of US$4.91b due beyond that. Offsetting these obligations, it had cash of US$264.1m as well as receivables valued at US$2.46m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$7.16b.

This deficit isn't so bad because Tractor Supply is worth a massive US$29.1b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Tractor Supply's net debt is only 0.77 times its EBITDA. And its EBIT easily covers its interest expense, being 32.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Fortunately, Tractor Supply grew its EBIT by 4.4% in the last year, making that debt load look even more manageable. 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 Tractor Supply'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Tractor Supply recorded free cash flow of 40% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On our analysis Tractor Supply's interest cover should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. When we consider all the elements mentioned above, it seems to us that Tractor Supply is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Tractor Supply , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com