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.' 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. We note that Innergex Renewable Energy Inc. (TSE:INE) 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 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. 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 Innergex Renewable Energy's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of March 2019 Innergex Renewable Energy had CA$4.71b of debt, an increase on CA$3.73b, over one year. However, because it has a cash reserve of CA$98.0m, its net debt is less, at about CA$4.62b.
A Look At Innergex Renewable Energy's Liabilities
The latest balance sheet data shows that Innergex Renewable Energy had liabilities of CA$994.4m due within a year, and liabilities of CA$4.81b falling due after that. Offsetting this, it had CA$98.0m in cash and CA$70.3m in receivables that were due within 12 months. So its liabilities total CA$5.63b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the CA$2.02b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt After all, Innergex Renewable Energy would likely require a major re-capitalisation if it had to pay its creditors today.
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).
Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 11.5 hit our confidence in Innergex Renewable Energy like a one-two punch to the gut. The debt burden here is substantial. On a lighter note, we note that Innergex Renewable Energy grew its EBIT by 20% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. 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 Innergex Renewable Energy's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Innergex Renewable Energy saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
On the face of it, Innergex Renewable Energy's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. After considering the datapoints discussed, we think Innergex Renewable Energy has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Given our concerns about Innergex Renewable Energy's debt levels, it seems only prudent to check if insiders have been ditching the stock.
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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