Incitec Pivot (ASX:IPL) Seems To Use Debt Quite Sensibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Incitec Pivot Limited (ASX:IPL) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Incitec Pivot

What Is Incitec Pivot's Net Debt?

As you can see below, at the end of March 2023, Incitec Pivot had AU$1.70b of debt, up from AU$1.55b a year ago. Click the image for more detail. However, because it has a cash reserve of AU$344.4m, its net debt is less, at about AU$1.35b.

How Healthy Is Incitec Pivot's Balance Sheet?

The latest balance sheet data shows that Incitec Pivot had liabilities of AU$1.37b due within a year, and liabilities of AU$2.68b falling due after that. On the other hand, it had cash of AU$344.4m and AU$601.8m worth of receivables due within a year. So it has liabilities totalling AU$3.11b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Incitec Pivot is worth AU$5.21b, 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 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.

With net debt sitting at just 0.89 times EBITDA, Incitec Pivot is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 9.5 times the interest expense over the last year. In addition to that, we're happy to report that Incitec Pivot has boosted its EBIT by 47%, thus reducing the spectre of future debt repayments. 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 Incitec Pivot'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Incitec Pivot's free cash flow amounted to 50% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Incitec Pivot's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its level of total liabilities. All these things considered, it appears that Incitec Pivot can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Incitec Pivot (at least 1 which shouldn't be ignored) , and understanding them should be part of your investment process.

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.