Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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, Independence Group NL (ASX:IGO) does carry debt. But should shareholders be worried about its use of debt?
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. If things get really bad, the lenders can take control of the business. 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 Independence Group's Debt?
The image below, which you can click on for greater detail, shows that Independence Group had debt of AU$112.7m at the end of December 2018, a reduction from AU$168.9m over a year. But on the other hand it also has AU$230.3m in cash, leading to a AU$117.6m net cash position.
How Strong Is Independence Group's Balance Sheet?
According to the last reported balance sheet, Independence Group had liabilities of AU$111.2m due within 12 months, and liabilities of AU$253.5m due beyond 12 months. On the other hand, it had cash of AU$230.3m and AU$48.3m worth of receivables due within a year. So its liabilities total AU$86.1m more than the combination of its cash and short-term receivables.
Given Independence Group has a market capitalization of AU$3.16b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time. While it does have liabilities worth noting, Independence Group also has more cash than debt, so we're pretty confident it can manage its debt safely.
Even more impressive was the fact that Independence Group grew its EBIT by 1466% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 Independence Group 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. Independence Group 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. Considering the last three years, Independence Group actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for and improvement.
We could understand if investors are concerned about Independence Group's liabilities, but we can be reassured by the fact it has has net cash of AU$118m. And we liked the look of last year's 1466% year-on-year EBIT growth. So we don't have any problem with Independence Group's use of debt. We'd be motivated to research the stock further if we found out that Independence Group insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
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.