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The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Inland Homes plc (LON:INL) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Inland Homes’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 Inland Homes had UK£126.8m of debt, an increase on UK£94.6m, over one year. On the flip side, it has UK£30.2m in cash leading to net debt of about UK£96.6m.
How Healthy Is Inland Homes’s Balance Sheet?
The latest balance sheet data shows that Inland Homes had liabilities of UK£71.9m due within a year, and liabilities of UK£95.7m falling due after that. Offsetting these obligations, it had cash of UK£30.2m as well as receivables valued at UK£40.7m due within 12 months. So its liabilities total UK£96.7m more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of UK£136.3m. So should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Either way, since Inland Homes does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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).
Inland Homes has a debt to EBITDA ratio of 3.91 and its EBIT covered its interest expense 4.44 times. This suggests that while the debt levels are significant, we’d stop short of calling them problematic. The good news is that Inland Homes grew its EBIT a smooth 59% over the last twelve months. Like a mother’s loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. 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 Inland Homes’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.
Finally, a business needs free cash flow to pay off debt; accounting profits just don’t cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Inland Homes saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Inland Homes’s conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Inland Homes’s debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. Given our hesitation about the stock, it would be good to know if Inland Homes insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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