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.' 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, ILPRA S.p.A. (BIT:ILP) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is ILPRA's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2020 ILPRA had €9.77m of debt, an increase on €7.16m, over one year. However, because it has a cash reserve of €3.62m, its net debt is less, at about €6.15m.
How Strong Is ILPRA's Balance Sheet?
We can see from the most recent balance sheet that ILPRA had liabilities of €15.8m falling due within a year, and liabilities of €7.92m due beyond that. Offsetting these obligations, it had cash of €3.62m as well as receivables valued at €12.1m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €8.00m.
ILPRA has a market capitalization of €22.0m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
ILPRA has a low net debt to EBITDA ratio of only 1.4. And its EBIT covers its interest expense a whopping 13.3 times over. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that ILPRA saw its EBIT decline by 2.8% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if ILPRA 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, ILPRA 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.
ILPRA's conversion of EBIT to free cash flow and EBIT growth rate definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that ILPRA is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for ILPRA (2 shouldn't be ignored!) that you should be aware of before investing here.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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