Here's Why Imperial Brands (LON:IMB) Can Manage Its Debt Responsibly

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 note that Imperial Brands PLC (LON:IMB) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Imperial Brands

What Is Imperial Brands's Debt?

As you can see below, Imperial Brands had UK£10.0b of debt, at September 2022, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has UK£1.86b in cash leading to net debt of about UK£8.19b.

How Strong Is Imperial Brands' Balance Sheet?

We can see from the most recent balance sheet that Imperial Brands had liabilities of UK£11.1b falling due within a year, and liabilities of UK£12.3b due beyond that. On the other hand, it had cash of UK£1.86b and UK£2.72b worth of receivables due within a year. So its liabilities total UK£18.9b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its very significant market capitalization of UK£19.3b, so it does suggest shareholders should keep an eye on Imperial Brands' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Imperial Brands's net debt to EBITDA ratio of about 2.2 suggests only moderate use of debt. And its strong interest cover of 1k times, makes us even more comfortable. Unfortunately, Imperial Brands saw its EBIT slide 3.6% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Imperial Brands 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Imperial Brands generated free cash flow amounting to a very robust 91% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.

Our View

Both Imperial Brands's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. Looking at all this data makes us feel a little cautious about Imperial Brands'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. To that end, you should be aware of the 3 warning signs we've spotted with Imperial Brands .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.