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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies IES Holdings, Inc. (NASDAQ:IESC) makes use of debt. But the more important question is: how much risk is that debt creating?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
Our analysis indicates that IESC is potentially undervalued!
What Is IES Holdings's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2022 IES Holdings had US$95.9m of debt, an increase on US$39.7m, over one year. However, it does have US$17.1m in cash offsetting this, leading to net debt of about US$78.8m.
How Healthy Is IES Holdings' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that IES Holdings had liabilities of US$366.8m due within 12 months and liabilities of US$137.8m due beyond that. Offsetting this, it had US$17.1m in cash and US$462.1m in receivables that were due within 12 months. So it has liabilities totalling US$25.4m more than its cash and near-term receivables, combined.
Of course, IES Holdings has a market capitalization of US$737.4m, 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.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
IES Holdings has a low net debt to EBITDA ratio of only 0.92. And its EBIT easily covers its interest expense, being 29.7 times the size. So we're pretty relaxed about its super-conservative use of debt. It is just as well that IES Holdings's load is not too heavy, because its EBIT was down 20% over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since IES Holdings will need earnings to service that debt. 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 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. In the last three years, IES Holdings's free cash flow amounted to 31% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Based on what we've seen IES Holdings is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its interest cover. When we consider all the factors mentioned above, we do feel a bit cautious about IES Holdings's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for IES Holdings you should know about.
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.
What are the risks and opportunities for IES Holdings?
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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.