Is Integral Diagnostics (ASX:IDX) A Risky Investment?

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.' 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 Integral Diagnostics Limited (ASX:IDX) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, 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. 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 Integral Diagnostics

What Is Integral Diagnostics's Debt?

The image below, which you can click on for greater detail, shows that at June 2020 Integral Diagnostics had debt of AU$157.0m, up from AU$122.9m in one year. However, because it has a cash reserve of AU$58.0m, its net debt is less, at about AU$99.0m.

How Healthy Is Integral Diagnostics's Balance Sheet?

We can see from the most recent balance sheet that Integral Diagnostics had liabilities of AU$69.8m falling due within a year, and liabilities of AU$282.3m due beyond that. On the other hand, it had cash of AU$58.0m and AU$14.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$279.7m.

This deficit isn't so bad because Integral Diagnostics is worth AU$861.7m, and thus could probably raise enough capital to shore up 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Integral Diagnostics's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 5.0 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. We saw Integral Diagnostics grow its EBIT by 3.1% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Integral Diagnostics 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Integral Diagnostics recorded free cash flow worth 55% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Integral Diagnostics's conversion of EBIT to free cash flow was a real positive on this analysis, as was its net debt to EBITDA. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. We would also note that Healthcare industry companies like Integral Diagnostics commonly do use debt without problems. When we consider all the elements mentioned above, it seems to us that Integral Diagnostics is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. For example, we've discovered 4 warning signs for Integral Diagnostics that you should be aware of before investing here.

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. 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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