ISC Fresh Water Investment SOCIMI (BME:YISC) Takes On Some Risk With Its Use Of 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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that ISC Fresh Water Investment SOCIMI, S.A. (BME:YISC) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for ISC Fresh Water Investment SOCIMI

What Is ISC Fresh Water Investment SOCIMI's Debt?

The image below, which you can click on for greater detail, shows that ISC Fresh Water Investment SOCIMI had debt of €178.2m at the end of June 2020, a reduction from €192.4m over a year. Net debt is about the same, since the it doesn't have much cash.

A Look At ISC Fresh Water Investment SOCIMI's Liabilities

We can see from the most recent balance sheet that ISC Fresh Water Investment SOCIMI had liabilities of €16.0m falling due within a year, and liabilities of €175.9m due beyond that. On the other hand, it had cash of €1.71m and €176.9k worth of receivables due within a year. So its liabilities total €190.1m more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of €138.7m, we think shareholders really should watch ISC Fresh Water Investment SOCIMI's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

ISC Fresh Water Investment SOCIMI has a rather high debt to EBITDA ratio of 8.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.4 times, suggesting it can responsibly service its obligations. However, one redeeming factor is that ISC Fresh Water Investment SOCIMI grew its EBIT at 11% over the last 12 months, boosting its ability to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But it is ISC Fresh Water Investment SOCIMI's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, ISC Fresh Water Investment SOCIMI actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Neither ISC Fresh Water Investment SOCIMI's ability handle its debt, based on its EBITDA, nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that ISC Fresh Water Investment SOCIMI is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with ISC Fresh Water Investment SOCIMI .

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.

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