Is QANTM Intellectual Property (ASX:QIP) Using Too Much Debt?

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. Importantly, QANTM Intellectual Property Limited (ASX:QIP) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for QANTM Intellectual Property

What Is QANTM Intellectual Property's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 QANTM Intellectual Property had AU$23.6m of debt, an increase on AU$12.1m, over one year. However, it also had AU$6.16m in cash, and so its net debt is AU$17.4m.

How Strong Is QANTM Intellectual Property's Balance Sheet?

The latest balance sheet data shows that QANTM Intellectual Property had liabilities of AU$26.2m due within a year, and liabilities of AU$38.1m falling due after that. Offsetting this, it had AU$6.16m in cash and AU$33.7m in receivables that were due within 12 months. So its liabilities total AU$24.4m more than the combination of its cash and short-term receivables.

Given QANTM Intellectual Property has a market capitalization of AU$152.6m, it's hard to believe these liabilities pose much 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). 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).

QANTM Intellectual Property's net debt is only 0.89 times its EBITDA. And its EBIT easily covers its interest expense, being 11.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that QANTM Intellectual Property saw its EBIT decline by 3.1% 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 QANTM Intellectual Property'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, QANTM Intellectual Property produced sturdy free cash flow equating to 73% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Happily, QANTM Intellectual Property's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its EBIT growth rate does undermine this impression a bit. When we consider the range of factors above, it looks like QANTM Intellectual Property is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. For instance, we've identified 1 warning sign for QANTM Intellectual Property that you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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