Here's Why Inchcape (LON:INCH) Can Manage Its Debt Responsibly

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.' 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. Importantly, Inchcape plc (LON:INCH) does carry debt. But the real question is whether this debt is making the company risky.

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Inchcape

What Is Inchcape's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Inchcape had UK£1.07b of debt in December 2021, down from UK£1.23b, one year before. However, it does have UK£596.6m in cash offsetting this, leading to net debt of about UK£472.0m.

How Healthy Is Inchcape's Balance Sheet?

The latest balance sheet data shows that Inchcape had liabilities of UK£1.74b due within a year, and liabilities of UK£685.4m falling due after that. On the other hand, it had cash of UK£596.6m and UK£277.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£1.55b.

While this might seem like a lot, it is not so bad since Inchcape has a market capitalization of UK£2.76b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Inchcape's net debt of 1.8 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 8.5 times its interest expenses harmonizes with that theme. We also note that Inchcape improved its EBIT from a last year's loss to a positive UK£227m. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Inchcape'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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Happily for any shareholders, Inchcape actually produced more free cash flow than EBIT over the last year. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

When it comes to the balance sheet, the standout positive for Inchcape was the fact that it seems able to convert EBIT to free cash flow confidently. But the other factors we noted above weren't so encouraging. For example, its level of total liabilities makes us a little nervous about its debt. When we consider all the elements mentioned above, it seems to us that Inchcape is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Inchcape you should know about.

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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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.