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.’ So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Inchcape plc (LON:INCH) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company’s use of debt, we first look at cash and debt together.
What Is Inchcape’s Debt?
You can click the graphic below for the historical numbers, but it shows that Inchcape had UK£2.06b of debt in June 2019, down from UK£2.61b, one year before. However, it also had UK£460.0m in cash, and so its net debt is UK£1.60b.
A Look At Inchcape’s Liabilities
We can see from the most recent balance sheet that Inchcape had liabilities of UK£2.66b falling due within a year, and liabilities of UK£1.01b due beyond that. On the other hand, it had cash of UK£460.0m and UK£634.9m worth of receivables due within a year. So it has liabilities totalling UK£2.58b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s UK£2.57b market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).
Inchcape has a debt to EBITDA ratio of 3.8, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 12.9 is very high, suggesting that the interest expense may well rise in the future, even if there hasn’t yet been a major cost attached to that debt. Unfortunately, Inchcape saw its EBIT slide 8.5% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 Inchcape’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 always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Inchcape recorded free cash flow worth 60% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Neither Inchcape’s ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Inchcape’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. In light of our reservations about the company’s balance sheet, it seems sensible to check if insiders have been selling shares recently.
When all is said and done, sometimes its easier to focus on companies that don’t even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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