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Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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. We can see that Inno-Gene S.A. (WSE:IGN) does use debt in its business. But is this debt a concern to shareholders?
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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well – and to its own advantage. The first step when considering a company’s debt levels is to consider its cash and debt together.
How Much Debt Does Inno-Gene Carry?
You can click the graphic below for the historical numbers, but it shows that Inno-Gene had zł647.5k of debt in March 2019, down from zł872.3k, one year before On the flip side, it has zł376.8k in cash leading to net debt of about zł270.7k.
How Strong Is Inno-Gene’s Balance Sheet?
We can see from the most recent balance sheet that Inno-Gene had liabilities of zł15.1m falling due within a year, and liabilities of zł746.0k due beyond that. On the other hand, it had cash of zł376.8k and zł2.50m worth of receivables due within a year. So it has liabilities totalling zł13.0m more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s zł10.8m market capitalization, you might well be inclined to review the balance sheet, just like one might study a new partner’s social media. 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. Because it carries more debt than cash, we think it’s worth watching Inno-Gene’s balance sheet 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). 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).
Inno-Gene has a low debt to EBITDA ratio of only 0.16. But the really cool thing is that it actually managed to receive more interest than it paid, over the last year. So it’s fair to say it can handle debt like a hot shot teppanyaki chef handles cooking. On the other hand, Inno-Gene saw its EBIT drop by 7.7% in the last twelve months. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Inno-Gene’s earnings that will influence how the balance sheet holds up in the future. So if you’re keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
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. Considering the last two years, Inno-Gene actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
To be frank both Inno-Gene’s level of total liabilities and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, we think it’s fair to say that Inno-Gene has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Over time, share prices tend to follow earnings per share, so if you’re interested in Inno-Gene, you may well want to click here to check an interactive graph of its earnings per share history.
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned. Thank you for reading.