Inchcape (LON:INCH) Seems To Use Debt Quite Sensibly

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 Inchcape plc (LON:INCH) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Inchcape

How Much Debt Does Inchcape Carry?

As you can see below, at the end of December 2022, Inchcape had UK£2.86b of debt, up from UK£1.07b a year ago. Click the image for more detail. However, it does have UK£1.06b in cash offsetting this, leading to net debt of about UK£1.80b.

How Strong Is Inchcape's Balance Sheet?

We can see from the most recent balance sheet that Inchcape had liabilities of UK£3.71b falling due within a year, and liabilities of UK£1.69b due beyond that. Offsetting these obligations, it had cash of UK£1.06b as well as receivables valued at UK£631.2m due within 12 months. So it has liabilities totalling UK£3.70b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of UK£3.27b, we think shareholders really should watch Inchcape's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Inchcape's net debt is 4.0 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 14.1 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. It is well worth noting that Inchcape's EBIT shot up like bamboo after rain, gaining 94% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Inchcape 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, Inchcape actually produced more free cash flow than EBIT over the last two years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Inchcape's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. When we consider all the elements mentioned above, it seems to us that Inchcape is managing its debt quite well. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. To that end, you should learn about the 3 warning signs we've spotted with Inchcape (including 1 which can't be ignored) .

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.