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

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. 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 is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See 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 as of June 2023 Inchcape had UK£2.83b of debt, an increase on UK£1.38b, over one year. However, because it has a cash reserve of UK£571.6m, its net debt is less, at about UK£2.26b.

How Strong Is Inchcape's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Inchcape had liabilities of UK£3.47b due within 12 months and liabilities of UK£1.67b due beyond that. Offsetting this, it had UK£571.6m in cash and UK£871.7m in receivables that were due within 12 months. So it has liabilities totalling UK£3.70b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's UK£2.74b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). 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).

Inchcape has a debt to EBITDA ratio of 3.8 and its EBIT covered its interest expense 5.8 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. It is well worth noting that Inchcape's EBIT shot up like bamboo after rain, gaining 53% in the last twelve months. That'll make it easier to manage its debt. 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'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. Over the last two years, Inchcape recorded free cash flow worth a fulsome 86% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

Our View

Both Inchcape's ability to to convert EBIT to free cash flow and its EBIT growth rate gave us comfort that it can handle its debt. But truth be told its level of total liabilities had us nibbling our nails. When we consider all the factors mentioned above, we do feel a bit cautious about Inchcape'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. Be aware that Inchcape is showing 3 warning signs in our investment analysis , and 1 of those shouldn'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.