Is Incitec Pivot (ASX:IPL) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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, Incitec Pivot Limited (ASX:IPL) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Incitec Pivot

How Much Debt Does Incitec Pivot Carry?

As you can see below, Incitec Pivot had AU$1.55b of debt, at March 2022, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of AU$215.3m, its net debt is less, at about AU$1.34b.

How Healthy Is Incitec Pivot's Balance Sheet?

According to the last reported balance sheet, Incitec Pivot had liabilities of AU$1.31b due within 12 months, and liabilities of AU$2.40b due beyond 12 months. Offsetting this, it had AU$215.3m in cash and AU$632.6m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$2.87b.

Incitec Pivot has a market capitalization of AU$7.34b, 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Incitec Pivot has a low net debt to EBITDA ratio of only 1.0. And its EBIT covers its interest expense a whopping 10.9 times over. So we're pretty relaxed about its super-conservative use of debt. Better yet, Incitec Pivot grew its EBIT by 268% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. 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 Incitec Pivot 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Incitec Pivot's free cash flow amounted to 39% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Incitec Pivot's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its interest cover is also very heartening. All these things considered, it appears that Incitec Pivot can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. Be aware that Incitec Pivot is showing 3 warning signs in our investment analysis , and 1 of those is concerning...

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.