David Iben put it well when he said, ‘Volatility is not a risk we care about. What we care about is avoiding the 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 IPH Limited (ASX:IPH) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is IPH’s Debt?
The image below, which you can click on for greater detail, shows that at December 2019 IPH had debt of AU$130.9m, up from AU$32.6m in one year. However, it also had AU$43.7m in cash, and so its net debt is AU$87.2m.
How Strong Is IPH’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that IPH had liabilities of AU$58.8m due within 12 months and liabilities of AU$250.1m due beyond that. On the other hand, it had cash of AU$43.7m and AU$82.9m worth of receivables due within a year. So its liabilities total AU$182.3m more than the combination of its cash and short-term receivables.
Since publicly traded IPH shares are worth a total of AU$1.59b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
IPH’s net debt is only 0.91 times its EBITDA. And its EBIT covers its interest expense a whopping 19.8 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Another good sign is that IPH has been able to increase its EBIT by 27% in twelve months, making it easier to pay down debt. 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 IPH’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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it’s worth checking how much of that EBIT is backed by free cash flow. During the last three years, IPH produced sturdy free cash flow equating to 79% of its EBIT, about what we’d expect. This cold hard cash means it can reduce its debt when it wants to.
IPH’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. Overall, we don’t think IPH is taking any bad risks, as its debt load seems modest. So we’re not worried about the use of a little leverage on the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it. For instance, we’ve identified 3 warning signs for IPH that you should be aware of.
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned.
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