The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 can see that Incitec Pivot Limited (ASX:IPL) does use debt in its business. But the real question is whether this debt is making the company risky.
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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 Incitec Pivot's Debt?
The image below, which you can click on for greater detail, shows that at March 2019 Incitec Pivot had debt of AU$2.49b, up from AU$2.26b in one year. However, because it has a cash reserve of AU$258.1m, its net debt is less, at about AU$2.24b.
A Look At Incitec Pivot's Liabilities
According to the last reported balance sheet, Incitec Pivot had liabilities of AU$2.38b due within 12 months, and liabilities of AU$2.00b due beyond 12 months. Offsetting this, it had AU$258.1m in cash and AU$366.1m in receivables that were due within 12 months. So it has liabilities totalling AU$3.75b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of AU$5.35b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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.
Incitec Pivot has a debt to EBITDA ratio of 3.3 and its EBIT covered its interest expense 3.0 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Another concern for investors might be that Incitec Pivot's EBIT fell 11% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Incitec Pivot 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.
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, Incitec Pivot recorded free cash flow worth a fulsome 80% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.
Neither Incitec Pivot's ability to grow its EBIT nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to convert EBIT to free cash flow with ease. When we consider all the factors discussed, it seems to us that Incitec Pivot is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. Given our hesitation about the stock, it would be good to know if Incitec Pivot insiders have sold any shares recently. You click here to find out if insiders have sold recently.
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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