Here's Why InvoCare (ASX:IVC) Has A Meaningful Debt Burden

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, InvoCare Limited (ASX:IVC) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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 InvoCare

What Is InvoCare's Debt?

As you can see below, at the end of December 2022, InvoCare had AU$200.6m of debt, up from AU$188.9m a year ago. Click the image for more detail. However, it does have AU$31.7m in cash offsetting this, leading to net debt of about AU$168.9m.

How Strong Is InvoCare's Balance Sheet?

We can see from the most recent balance sheet that InvoCare had liabilities of AU$203.3m falling due within a year, and liabilities of AU$988.8m due beyond that. Offsetting these obligations, it had cash of AU$31.7m as well as receivables valued at AU$66.8m due within 12 months. So its liabilities total AU$1.09b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of AU$1.60b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While InvoCare has a quite reasonable net debt to EBITDA multiple of 1.7, its interest cover seems weak, at 1.9. This does have us wondering if the company pays high interest because it is considered risky. Either way there's no doubt the stock is using meaningful leverage. Unfortunately, InvoCare saw its EBIT slide 6.3% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if InvoCare 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. In the last three years, InvoCare created free cash flow amounting to 9.1% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Mulling over InvoCare's attempt at covering its interest expense with its EBIT, we're certainly not enthusiastic. But at least its net debt to EBITDA is not so bad. Looking at the bigger picture, it seems clear to us that InvoCare's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. While InvoCare didn't make a statutory profit in the last year, its positive EBIT suggests that profitability might not be far away. Click here to see if its earnings are heading in the right direction, over the medium term.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.