David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, Incitec Pivot Limited (ASX:IPL) does carry debt. But the real question is whether this debt is making the company risky.
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. If things get really bad, the lenders can take control of the business. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Incitec Pivot Carry?
The image below, which you can click on for greater detail, shows that Incitec Pivot had debt of AU$1.87b at the end of September 2020, a reduction from AU$2.66b over a year. However, because it has a cash reserve of AU$634.4m, its net debt is less, at about AU$1.24b.
A Look At Incitec Pivot's Liabilities
According to the last reported balance sheet, Incitec Pivot had liabilities of AU$1.33b due within 12 months, and liabilities of AU$2.76b due beyond 12 months. Offsetting these obligations, it had cash of AU$634.4m as well as receivables valued at AU$373.9m due within 12 months. So its liabilities total AU$3.08b more than the combination of its cash and short-term receivables.
Incitec Pivot has a market capitalization of AU$5.50b, so it could very likely raise cash to ameliorate 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.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While Incitec Pivot has a quite reasonable net debt to EBITDA multiple of 2.0, its interest cover seems weak, at 2.4. This does suggest the company is paying fairly high interest rates. Either way there's no doubt the stock is using meaningful leverage. Also relevant is that Incitec Pivot has grown its EBIT by a very respectable 20% in the last year, thus enhancing its ability to pay down debt. 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 Incitec Pivot'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Incitec Pivot recorded free cash flow worth 62% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Incitec Pivot's interest cover was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to grow its EBIT is pretty flash. Looking at all this data makes us feel a little cautious about Incitec Pivot's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 - Incitec Pivot has 2 warning signs we think you should be aware of.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
If you’re looking to trade Incitec Pivot, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted
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.
*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.