Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies INSPECS Group plc (LON:SPEC) makes use of debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does INSPECS Group Carry?
You can click the graphic below for the historical numbers, but it shows that as of June 2022 INSPECS Group had US$56.8m of debt, an increase on US$54.6m, over one year. On the flip side, it has US$30.6m in cash leading to net debt of about US$26.2m.
A Look At INSPECS Group's Liabilities
We can see from the most recent balance sheet that INSPECS Group had liabilities of US$79.0m falling due within a year, and liabilities of US$89.5m due beyond that. Offsetting these obligations, it had cash of US$30.6m as well as receivables valued at US$39.5m due within 12 months. So its liabilities total US$98.4m more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the US$59.8m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, INSPECS Group would likely require a major re-capitalisation if it had to pay its creditors today.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While INSPECS Group's low debt to EBITDA ratio of 1.2 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.3 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Notably, INSPECS Group's EBIT launched higher than Elon Musk, gaining a whopping 775% on last year. 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 INSPECS Group'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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, INSPECS Group generated free cash flow amounting to a very robust 99% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
INSPECS Group's level of total liabilities was a real negative on this analysis, although the other factors we considered were considerably better. There's no doubt that its ability to to convert EBIT to free cash flow is pretty flash. We would also note that Medical Equipment industry companies like INSPECS Group commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about INSPECS Group's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 4 warning signs for INSPECS Group (3 are concerning!) that you should be aware of before investing here.
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.