These 4 Measures Indicate That International Paper (NYSE:IP) Is Using Debt Extensively

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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, International Paper Company (NYSE:IP) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for International Paper

How Much Debt Does International Paper Carry?

The image below, which you can click on for greater detail, shows that International Paper had debt of US$8.00b at the end of December 2020, a reduction from US$9.67b over a year. However, it also had US$5.45b in cash, and so its net debt is US$2.55b.

How Healthy Is International Paper's Balance Sheet?

The latest balance sheet data shows that International Paper had liabilities of US$8.28b due within a year, and liabilities of US$15.6b falling due after that. Offsetting these obligations, it had cash of US$5.45b as well as receivables valued at US$3.42b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$15.0b.

This is a mountain of leverage even relative to its gargantuan market capitalization of US$20.5b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While International Paper's low debt to EBITDA ratio of 0.86 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.9 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Shareholders should be aware that International Paper's EBIT was down 28% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if International Paper 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, International Paper generated free cash flow amounting to a very robust 96% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

Neither International Paper's ability to grow its EBIT nor its level of total liabilities gave us confidence in its ability to take on more debt. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think International Paper's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that International Paper is showing 5 warning signs in our investment analysis , you should know about...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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