Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 i3 Verticals, Inc. (NASDAQ:IIIV) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does i3 Verticals Carry?
The image below, which you can click on for greater detail, shows that at December 2020 i3 Verticals had debt of US$141.4m, up from US$132.3m in one year. However, it does have US$10.9m in cash offsetting this, leading to net debt of about US$130.5m.
How Healthy Is i3 Verticals' Balance Sheet?
The latest balance sheet data shows that i3 Verticals had liabilities of US$59.9m due within a year, and liabilities of US$196.4m falling due after that. Offsetting these obligations, it had cash of US$10.9m as well as receivables valued at US$23.8m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$221.6m.
While this might seem like a lot, it is not so bad since i3 Verticals has a market capitalization of US$1.07b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
Weak interest cover of 0.25 times and a disturbingly high net debt to EBITDA ratio of 7.7 hit our confidence in i3 Verticals like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, i3 Verticals's EBIT was down 82% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if i3 Verticals 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, i3 Verticals actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Neither i3 Verticals's ability to grow its EBIT nor its interest cover 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 i3 Verticals's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For instance, we've identified 1 warning sign for i3 Verticals that you should be aware of.
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.
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