Does IPH (ASX:IPH) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that IPH Limited (ASX:IPH) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for IPH

What Is IPH's Debt?

The image below, which you can click on for greater detail, shows that IPH had debt of AU$116.4m at the end of December 2020, a reduction from AU$130.9m over a year. However, it does have AU$59.8m in cash offsetting this, leading to net debt of about AU$56.7m.

How Strong Is IPH's Balance Sheet?

According to the last reported balance sheet, IPH had liabilities of AU$53.6m due within 12 months, and liabilities of AU$210.9m due beyond 12 months. Offsetting this, it had AU$59.8m in cash and AU$80.5m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$124.3m.

Since publicly traded IPH shares are worth a total of AU$1.42b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

IPH's net debt is only 0.54 times its EBITDA. And its EBIT covers its interest expense a whopping 14.5 times over. So we're pretty relaxed about its super-conservative use of debt. IPH's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if IPH can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, IPH generated free cash flow amounting to a very robust 96% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

The good news is that IPH's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its conversion of EBIT to free cash flow also supports that impression! Looking at the bigger picture, we think IPH's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. We've identified 1 warning sign with IPH , 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. 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.
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