Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Innospec Inc. (NASDAQ:IOSP) does carry debt. But the more important question is: how much risk is that debt creating?
Why Does Debt Bring Risk?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Innospec's Debt?
The image below, which you can click on for greater detail, shows that Innospec had debt of US$38.8m at the end of June 2020, a reduction from US$158.7m over a year. However, it does have US$58.2m in cash offsetting this, leading to net cash of US$19.4m.
How Strong Is Innospec's Balance Sheet?
The latest balance sheet data shows that Innospec had liabilities of US$219.2m due within a year, and liabilities of US$220.1m falling due after that. Offsetting these obligations, it had cash of US$58.2m as well as receivables valued at US$213.4m due within 12 months. So its liabilities total US$167.7m more than the combination of its cash and short-term receivables.
Since publicly traded Innospec shares are worth a total of US$1.68b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. Despite its noteworthy liabilities, Innospec boasts net cash, so it's fair to say it does not have a heavy debt load!
The modesty of its debt load may become crucial for Innospec if management cannot prevent a repeat of the 26% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. 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 Innospec 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. Innospec 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. During the last three years, Innospec produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
While it is always sensible to look at a company's total liabilities, it is very reassuring that Innospec has US$19.4m in net cash. The cherry on top was that in converted 71% of that EBIT to free cash flow, bringing in US$102m. So we don't have any problem with Innospec's use of debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Innospec is showing 3 warning signs in our investment analysis , you should know about...
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.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email email@example.com.