These 4 Measures Indicate That IPH (ASX:IPH) Is Using Debt Reasonably Well

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See 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$116.9m at the end of June 2021, a reduction from AU$152.2m over a year. However, it also had AU$71.2m in cash, and so its net debt is AU$45.7m.

How Healthy Is IPH's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that IPH had liabilities of AU$60.7m due within 12 months and liabilities of AU$187.2m due beyond that. Offsetting this, it had AU$71.2m in cash and AU$90.0m in receivables that were due within 12 months. So it has liabilities totalling AU$86.7m more than its cash and near-term receivables, combined.

Since publicly traded IPH shares are worth a total of AU$1.94b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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 0.44 times its EBITDA. And its EBIT covers its interest expense a whopping 17.4 times over. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that IPH saw its EBIT decline by 5.5% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. The balance sheet is clearly the area to focus on when you are analysing debt. 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'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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, IPH recorded free cash flow worth a fulsome 97% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Happily, IPH's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its EBIT growth rate. 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. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 1 warning sign we've spotted with IPH .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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.

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