David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital. 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 note that Inspired Energy PLC (LON:INSE) does have debt on its balance sheet. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free 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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.
What Is Inspired Energy's Debt?
The image below, which you can click on for greater detail, shows that at June 2019 Inspired Energy had debt of UK£27.7m, up from UK£23.4m in one year. However, it also had UK£2.46m in cash, and so its net debt is UK£25.2m.
How Strong Is Inspired Energy's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Inspired Energy had liabilities of UK£12.8m due within 12 months and liabilities of UK£29.2m due beyond that. On the other hand, it had cash of UK£2.46m and UK£23.3m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£16.3m.
Of course, Inspired Energy has a market capitalization of UK£107.1m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a debt to EBITDA ratio of 2.2, Inspired Energy uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.9 times interest expense) certainly does not do anything to dispel this impression. It is well worth noting that Inspired Energy's EBIT shot up like bamboo after rain, gaining 43% in the last twelve months. That'll make it easier to manage its debt. 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 Inspired Energy 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Inspired Energy produced sturdy free cash flow equating to 59% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
The good news is that Inspired Energy's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. And we also thought its interest cover was a positive. When we consider the range of factors above, it looks like Inspired Energy is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Inspired Energy's dividend history, without delay!
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.
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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.