Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Trecora Resources (NYSE:TREC) makes use of debt. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

View our latest analysis for Trecora Resources

What Is Trecora Resources's Net Debt?

As you can see below, Trecora Resources had US$98.4m of debt at June 2019, down from US$105.1m a year prior. However, because it has a cash reserve of US$4.33m, its net debt is less, at about US$94.1m.

How Healthy Is Trecora Resources's Balance Sheet?

We can see from the most recent balance sheet that Trecora Resources had liabilities of US$25.0m falling due within a year, and liabilities of US$123.6m due beyond that. Offsetting these obligations, it had cash of US$4.33m as well as receivables valued at US$30.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$113.7m.

This deficit isn't so bad because Trecora Resources is worth US$219.2m, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Trecora Resources's debt to EBITDA ratio (4.1) suggests that it uses some debt, its interest cover is very weak, at 1.1, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. Even worse, Trecora Resources saw its EBIT tank 63% over the last 12 months. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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 Trecora Resources's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.