We Think Integral Diagnostics (ASX:IDX) Can Stay On Top Of Its 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, Integral Diagnostics Limited (ASX:IDX) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 step when considering a company's debt levels is to consider its cash and debt together.

View 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 December 2020 Integral Diagnostics had debt of AU$190.2m, up from AU$138.3m in one year. However, because it has a cash reserve of AU$68.8m, its net debt is less, at about AU$121.5m.

A Look At Integral Diagnostics' Liabilities

According to the last reported balance sheet, Integral Diagnostics had liabilities of AU$76.6m due within 12 months, and liabilities of AU$325.9m due beyond 12 months. On the other hand, it had cash of AU$68.8m and AU$11.6m worth of receivables due within a year. So its liabilities total AU$322.2m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Integral Diagnostics is worth AU$930.3m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). 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).

Integral Diagnostics's net debt is sitting at a very reasonable 1.7 times its EBITDA, while its EBIT covered its interest expense just 6.1 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Also relevant is that Integral Diagnostics has grown its EBIT by a very respectable 23% in the last year, thus enhancing its ability to pay down debt. 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 Integral Diagnostics'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Integral Diagnostics produced sturdy free cash flow equating to 65% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Integral Diagnostics's impressive EBIT growth rate implies it has the upper hand on its debt. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. It's also worth noting that Integral Diagnostics is in the Healthcare industry, which is often considered to be quite defensive. Taking all this data into account, it seems to us that Integral Diagnostics takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Integral Diagnostics is showing 2 warning signs in our investment analysis , you should know about...

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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