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. As with many other companies IDOX plc (LON:IDOX) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, 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.
What Is IDOX's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of October 2020 IDOX had UK£46.9m of debt, an increase on UK£33.4m, over one year. However, it does have UK£30.8m in cash offsetting this, leading to net debt of about UK£16.1m.
How Strong Is IDOX's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that IDOX had liabilities of UK£35.4m due within 12 months and liabilities of UK£55.9m due beyond that. Offsetting this, it had UK£30.8m in cash and UK£17.3m in receivables that were due within 12 months. So it has liabilities totalling UK£43.2m more than its cash and near-term receivables, combined.
Of course, IDOX has a market capitalization of UK£235.8m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
IDOX's net debt is sitting at a very reasonable 1.9 times its EBITDA, while its EBIT covered its interest expense just 2.8 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Notably, IDOX's EBIT launched higher than Elon Musk, gaining a whopping 190% on last year. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if IDOX can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, IDOX 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.
Happily, IDOX's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But we must concede we find its interest cover has the opposite effect. When we consider the range of factors above, it looks like IDOX is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that IDOX is showing 2 warning signs in our investment analysis , 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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