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Can Tesla Pay Its Debt?

Tesla Gigafactory Shanghai, China. Source: Tesla 1Q20 Update Letter.

The question of whether Tesla can pay its debt is actually not so important because the company can always go back to the capital market to raise more funds either through debts or equity. Thereafter, Tesla will use the new funds to pay off existing debts that come due. Sounds familiar?

This is what we call re-financing and it’s similar to re-financing your existing mortgages with new mortgages, but with better rates. Most big corporations like Tesla are doing the same thing which is refinancing their existing debts because they do not really want to pay off the debts even if they have the means to do it.

Reason? Most companies are getting better return on investment or ROI when they re-invest the cash back into the businesses instead of using the cash to pay off the debts. Besides, debts are incredibly cheap now and the expenses on debts are tax deductible. So why bother?

For the reason mentioned, what we need to look at is the question of whether Tesla can service its debts. In this aspect, we are looking at the company’s ability to cover the interest expenses as a result of the debts by using the profits or cash generated from the underlying business.

If Tesla failed to cover or service the interest expenses on a consistent basis, it means that the debts has become excessive and even dangerous which can cause the company to collapse.

You may argue that Tesla can alternatively use the borrowed capitals or the new funds to cover the interest expenses. However, this practice is not sustainable in the long run because it means that the company’s business has failed to grow sustainably to generate enough profits or cash to service the debts. In this case, Tesla will have to constantly go back to the capital markets for more funds which will result in more debts for the company.

Eventually, Tesla will find the piling debt obligations increasingly difficult to meet as a result of the increasing interest expenses and thus, resulting in the business going burst.

With all that said, in this article, we will look at Tesla’s ability to service its debts. Specifically, we will look at the sustainability of the company’s underlying business in terms of profit and cash generation. Subsequently, we will measure whether the generated profits and cash are enough to cover the total interest payable.

In this aspect, ratios such as the interest coverage or times interest earned are exactly what we need in order to measure Tesla’s sustainable way of paying or servicing its debts.

Let’s dive in!

Tesla’s Interest Expense

Tesla interest expense

Tesla interest expense

Before going straight to analyzing the said interest coverage or times interest earned ratios, let’s first look at Tesla’s interest expense over the past 5 years from 2015 to 2020 as depicted in the chart above.

As the above chart shows, Tesla’s interest expense has grown exponentially from a quarterly value of only $26 million in 1Q 2015 to as much as $169 million in 1Q 2020. Most of the growth in interest expense occurred between 2015 and 2018 and the figure reached the peak at around $170 million in 2018. Going into 2020, Tesla’s interest expense remained flat at this level.

According to Tesla, the growth in interest expense for the last 5 years has been largely driven by the increases in indebtedness as shown in this article: Tesla debt obligation.

Tesla’s EBIT

As discussed, the ratio that we are going to use to measure Tesla’s ability to sustainably meet its debt obligations is the interest coverage or times interest earned ratio.

The interest coverage ratio formula is shown as below:

Interest coverage ratio = earnings before interest and tax (EBIT) / interest payable

According to the formula above, one of the required variables is EBIT or earnings before interest and tax.

In Tesla case, the EBIT is basically the operating income of the company. The operating income measures Tesla’s profitability before interest and taxes are accounted for, but after all operating expenses such as cost of sales, depreciation, research and development (R&D) as well as selling, general and administrative (SGA) costs are accounted for in the income statements.

The metric purely reflects the operating strength of the company by excluding all non-operating related activities such as taxes, interest payable as well as other gains or losses resulting from currency translation or sales of any assets.

The EBIT is an extremely important variable in the sense that it represents a sustainable and renewable source of income for Tesla.

In other words, when we measure Tesla’s interest coverage ratio, we are evaluating the company’s debt servicing capability with respect to its underlying operating strength. In this case, the operating strength is represented by the EBIT.

For this reason, I have created the following chart that depicts Tesla’s EBIT for the last 5 years between 2015 and 2020.

Tesla EBIT or operating income

Tesla EBIT or operating income

According to the chart above, Tesla’s EBIT or operating income has mostly been negative for the last 5 years. However, we are seeing an improvement to the company EBIT in recent years. Specifically, Tesla’s EBIT has been positive over several quarters between 2018 and 2020. And Tesla managed to generate positive EBIT consecutively for the past 3 quarters from 3Q19 to 1Q20.

While Tesla has operated in a loss in most quarters, the company has been able to reduce losses since 2018 on a yearly basis. For instance, Tesla’s EBIT in 2018 was -$388 million and further on, the operating loss was reduced to only -$69 million in 2019, representing a year over year improvement of more than 80%.

Tesla’s EBITDA

Instead of using EBIT when measuring Tesla’s interest coverage ratio or times interest earned ratio, we can alternatively switch to using EBITDA which stands for earnings before interest, tax, depreciation and amortization.

The formula for measuring the interest coverage ratio will be the same except for the numerator part where EBITDA is used as shown below:

Interest coverage ratio = earnings before interest, tax, depreciation and amortization (EBITDA) / interest payable

The purpose of using EBITDA instead of EBIT when measuring interest coverage ratio is to evaluate Tesla’s debt servicing capabilities with respect to cash flow instead of profit. As we all know, cash is king when it comes to everything, be it paying off liabilities or purchasing assets, especially in time of a slowing economy.

According to accounting rules, the main difference between EBITDA and EBIT is depreciation and amortization. In this regard, EBIT includes depreciation and amortization charges whereas EBITDA excludes both. As a result, EBITDA represents the cash flow generated off from the normal trading activities of the business before any provision is made for reinvestment in fixed assets, changes in operating assets and liabilities, etc.

The following diagram illustrates where EBITDA is located in the cash flow hierarchy:

EBITDA

EBITDA diagram

Based on the diagram above, EBITDA sits between EBIT and cash flow from operating activities.

Basically, you can say that EBITDA is pure cash inflow that is thrown off from the normal course of the business operation that is sustainable and hopefully growing in the future. Moreover, EBITDA is largely free from distortions that can arise from accounting rules such as depreciation and amortization which usually exist in EBIT.

For all the reasons mentioned, we will also evaluate Tesla’s interest coverage ratio with respect to EBITDA. In here, I have created a chart below that shows Tesla’s EBITDA for the last 5 years from 2015 to 2020.

Tesla EBITDA

Tesla EBITDA

According to Tesla, EBITDA is calculated based on the following formula and is slightly adjusted to account for stock base compensation expense:

Adjusted EBITDA = Net Income Available to Common Stockholders + Interest Expense + Provision for Income Tax + Depreciation, Amortization and Impairment + Stock Based Compensation

As you can see in the chart above, Tesla’s EBITDA has been in much better shape compared to the chart of EBIT. In the EBITDA chart above, we can see that Tesla’s cash flow has been mainly positive and has in fact, been improving from 2018 to 2020. Some of the figures even reached more than $1 billion of positive cash flow.

In 1Q 2020, Tesla’s EBITDA of $951 million represents a year over year growth of roughly 500% compared to the corresponding quarter a year earlier.

In short, Tesla has managed to generate a stream of cash flow which is sustainable and renewable as seen in the EBITDA chart and this stream of cash flow has improved tremendously between 2018 and 2020.

Tesla’s Interest Coverage with respect to EBIT

Tesla EBIT-based interest coverage ratio

Tesla EBIT-based interest coverage ratio

Since we have the EBIT mapped out in a chart, we are now ready to further analyze Tesla’s interest coverage ratio with respect to EBIT which is depicted in the chart above.

Based on the chart, Tesla’s interest coverage or times interest earned ratios were mostly negative in most quarterly results, indicating that the company’s generated operating profits were not enough to cover the interest expenses.

The negative figures in the chart were expected as we have seen in prior discussion that Tesla’s EBIT was mostly negative in most quarters over the past 5 years.

In line with the improving EBIT in recent years, Tesla’s interest coverage ratio or times interest earned ratio has also been improving between 2018 and 2020 and managed to achieve 3 consecutive quarters of positive ratios from 3Q19 to 1Q20.

As of 1Q 2020, Tesla’s time interest earned ratio of 1.7 implies that the company’s EBIT or operating income was 1.7 times higher than the interest expense in the same quarter.

Is the interest coverage ratio of 1.7 a good or bad number? There is really no right or wrong answer to this question. What’s important is the trend on a long-term basis and we are seeing from the chart that Tesla has managed to improve the interest coverage over the last 5 years from mostly negative to slightly positive.

Therefore, this is a good trend and bodes well for investors who have invested in Tesla’s stock on a long-term horizon.

Do note that on a yearly basis, Tesla still ran into deficit in 2018 and 2019 in terms of times interest earned ratio. As such, Tesla is not out of the woods yet and investors should keep an eye on this ratio from quarter to quarter.

Tesla’s Interest Coverage with respect to EBITDA

Tesla EBITDA-based interest coverage ratio

Tesla EBITDA-based interest coverage ratio

As discussed, cash is king and all companies including Tesla literally pays out everything in cash and that includes interest expenses. Therefore, we should also be evaluating Tesla’s debts servicing capabilities with respect to cash flow or EBITDA to be precise.

To recap, EBITDA represents a continuous and sustainable streams of cash flow that is generated from the company operating activities. In Tesla case, its operating activities are energy and electric vehicles manufacturing as well as retailing which includes everything along the operating chain from raw materials purchasing to shipping end products to the customers.

Moreover, EBITDA also represents streams of cash before any adjustment is made for changes in operating assets and liabilities, fixed asset purchase, etc and is also free from any accounting distortion by excluding certain items such as depreciation, amortization and impairments. In Tesla’s case, stock based compensation is also excluded when measuring EBITDA.

Coming back to the interest coverage ratio chart above, we can see that the results are much better than the EBIT-based interest coverage ratio. In the current chart, Tesla’s EBITDA-based times interest earned ratios were mostly positive and in fact, have been improving especially between 2018 and 2020.

As of 1Q 2020, Tesla managed to achieve an interest coverage ratio of as much as 5.6, implying that the company’s EBITDA cash flow was 5 times more than the interest payable in the same quarter.

On a yearly basis, Tesla also managed to achieve positive times interest earned ratio between 2016 and 2019, indicating that the company has no problem covering the respective interest expenses with cash for the past 4 years.

You may notice that Tesla’s interest coverage ratios plunged to almost 0 between 2017 and 2018 in 4 consecutive quarters. I believe the decline was mostly due to the ramping of Model 3 which started in mid-2017. During these periods, Tesla has mostly consumed large amount of cash for working capital which has caused the ratio to plunge to near 0.

All in all, Tesla’s interest coverage with respect to EBITDA has mostly been positive, indicating that the company has been having enough liquidity to cover the interest expenses.

Conclusion

Can Tesla pay its debt? Yes, Tesla has been able to cover most of its interest expenses between 2016 and 2020 when we look at the interest coverage or times interest earned ratio with respect to EBITDA.

However, when we evaluate Tesla’s debt servicing ability with respect to EBIT or operating income, Tesla fell short in most quarterly results and has not been able to cover the respective interest payable for the last 5 years.

While Tesla ran into deficit when it comes to meeting its debt obligations, the company has made tremendous improvement in recent quarters. From 3Q19 to 1Q20, Tesla has managed to report positive interest coverage or times interest earned ratio of 1.4, 2.1 and 1.7 respectively, indicating that the company’s EBIT or operating income has been more than sufficient to cover the interest expenses over the recent quarters.

References and Credits

1. All information including financial figures in this article was obtained and referenced from the financial statements available in Tesla Investor Overview.

2. Featured images were used under Creative Common Licenses and were obtained from Jakob Härter.

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