Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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. We can see that Invesque Inc. (TSE:IVQ) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.
What Is Invesque's Debt?
The image below, which you can click on for greater detail, shows that Invesque had debt of US$971.3m at the end of December 2021, a reduction from US$1.15b over a year. And it doesn't have much cash, so its net debt is about the same.
How Strong Is Invesque's Balance Sheet?
We can see from the most recent balance sheet that Invesque had liabilities of US$91.1m falling due within a year, and liabilities of US$923.4m due beyond that. Offsetting this, it had US$19.4m in cash and US$20.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$975.0m.
This deficit casts a shadow over the US$79.4m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Invesque would likely require a major re-capitalisation if it had to pay its creditors today.
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). 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).
Invesque shareholders face the double whammy of a high net debt to EBITDA ratio (12.5), and fairly weak interest coverage, since EBIT is just 1.6 times the interest expense. This means we'd consider it to have a heavy debt load. The silver lining is that Invesque grew its EBIT by 556% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. 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 Invesque'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Invesque's free cash flow amounted to 46% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
To be frank both Invesque's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. Looking at the bigger picture, it seems clear to us that Invesque's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. We've identified 3 warning signs with Invesque (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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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.