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 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 Insimbi Industrial Holdings Limited (JSE:ISB) makes use of debt. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
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, 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 Insimbi Industrial Holdings Carry?
You can click the graphic below for the historical numbers, but it shows that as of August 2020 Insimbi Industrial Holdings had R676.2m of debt, an increase on R414.2m, over one year. However, it also had R126.0m in cash, and so its net debt is R550.2m.
A Look At Insimbi Industrial Holdings' Liabilities
According to the last reported balance sheet, Insimbi Industrial Holdings had liabilities of R459.9m due within 12 months, and liabilities of R405.9m due beyond 12 months. Offsetting this, it had R126.0m in cash and R385.2m in receivables that were due within 12 months. So it has liabilities totalling R354.7m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of R253.5m, we think shareholders really should watch Insimbi Industrial Holdings's debt levels, like a parent watching their child ride a bike for the first time. 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.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
Weak interest cover of 0.83 times and a disturbingly high net debt to EBITDA ratio of 6.8 hit our confidence in Insimbi Industrial Holdings like a one-two punch to the gut. The debt burden here is substantial. Even worse, Insimbi Industrial Holdings saw its EBIT tank 60% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 Insimbi Industrial 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Insimbi Industrial Holdings recorded free cash flow worth 77% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
To be frank both Insimbi Industrial Holdings's interest cover and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Overall, it seems to us that Insimbi Industrial Holdings's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Insimbi Industrial Holdings (of which 2 are a bit concerning!) you should know about.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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Insimbi Industrial Holdings
Insimbi Industrial Holdings Limited provides ferrous and non-ferrous alloys, and refractory materials for the steel, aluminum, cement, foundry, plastics, paper, and pulp industries.
Solid track record, good value and pays a dividend.