Is IPH (ASX:IPH) A Risky Investment?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for IPH

What Is IPH's Debt?

As you can see below, at the end of December 2022, IPH had AU$377.0m of debt, up from AU$119.5m a year ago. Click the image for more detail. However, it also had AU$92.2m in cash, and so its net debt is AU$284.8m.

How Strong Is IPH's Balance Sheet?

The latest balance sheet data shows that IPH had liabilities of AU$151.1m due within a year, and liabilities of AU$513.7m falling due after that. On the other hand, it had cash of AU$92.2m and AU$144.1m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$428.5m.

IPH has a market capitalization of AU$1.82b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

We'd say that IPH's moderate net debt to EBITDA ratio ( being 2.4), indicates prudence when it comes to debt. And its commanding EBIT of 11.0 times its interest expense, implies the debt load is as light as a peacock feather. If IPH can keep growing EBIT at last year's rate of 17% over the last year, then it will find its debt load easier to manage. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, IPH actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

The good news is that IPH's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its interest cover 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. After all, sensible leverage can boost returns on equity. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.