David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Ingevity Corporation (NYSE:NGVT) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Ingevity's Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Ingevity had US$1.39b of debt, an increase on US$748.3m, over one year. However, it also had US$53.7m in cash, and so its net debt is US$1.34b.
A Look At Ingevity's Liabilities
We can see from the most recent balance sheet that Ingevity had liabilities of US$216.0m falling due within a year, and liabilities of US$1.51b due beyond that. Offsetting these obligations, it had cash of US$53.7m as well as receivables valued at US$182.9m due within 12 months. So it has liabilities totalling US$1.49b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Ingevity has a market capitalization of US$3.92b, 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 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). 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).
With net debt to EBITDA of 3.8 Ingevity has a fairly noticeable amount of debt. On the plus side, its EBIT was 7.1 times its interest expense, and its net debt to EBITDA, was quite high, at 3.8. We note that Ingevity grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Ingevity's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Ingevity recorded free cash flow worth 51% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
On our analysis Ingevity's EBIT growth rate should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its net debt to EBITDA makes us a little nervous about its debt. Considering this range of data points, we think Ingevity is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Of course, we wouldn't say no to the extra confidence that we'd gain if we knew that Ingevity insiders have been buying shares: if you're on the same wavelength, you can find out if insiders are buying by clicking this link.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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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.