Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Incyte Corporation (NASDAQ:INCY) does use debt in its business. But the more important question is: how much risk is that debt creating?
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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Incyte's Debt?
The image below, which you can click on for greater detail, shows that Incyte had debt of US$17.9m at the end of June 2019, a reduction from US$24.6m over a year. However, its balance sheet shows it holds US$1.70b in cash, so it actually has US$1.68b net cash.
How Strong Is Incyte's Balance Sheet?
According to the last reported balance sheet, Incyte had liabilities of US$367.1m due within 12 months, and liabilities of US$333.3m due beyond 12 months. Offsetting these obligations, it had cash of US$1.70b as well as receivables valued at US$302.7m due within 12 months. So it can boast US$1.30b more liquid assets than total liabilities.
This surplus suggests that Incyte has a conservative balance sheet, and could probably eliminate its debt without much difficulty. Simply put, the fact that Incyte has more cash than debt is arguably a good indication that it can manage its debt safely.
Although Incyte made a loss at the EBIT level, last year, it was also good to see that it generated US$311m in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Incyte can strengthen its balance sheet over time. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. Incyte may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the last year, Incyte actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
While it is always sensible to investigate a company's debt, in this case Incyte has US$1.7b in net cash and a decent-looking balance sheet. And it impressed us with free cash flow of US$476m, being 153% of its EBIT. So we don't think Incyte's use of debt is risky. Over time, share prices tend to follow earnings per share, so if you're interested in Incyte, you may well want to click here to check an interactive graph of its earnings per share history.
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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