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. 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. As with many other companies International Flavors & Fragrances Inc. (NYSE:IFF) makes use of debt. But the real question is whether this debt is making the company risky.
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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is International Flavors & Fragrances's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 International Flavors & Fragrances had US$4.51b of debt, an increase on US$1.75b, over one year. On the flip side, it has US$426.7m in cash leading to net debt of about US$4.09b.
How Strong Is International Flavors & Fragrances's Balance Sheet?
The latest balance sheet data shows that International Flavors & Fragrances had liabilities of US$1.15b due within a year, and liabilities of US$5.87b falling due after that. On the other hand, it had cash of US$426.7m and US$1.05b worth of receivables due within a year. So its liabilities total US$5.55b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because International Flavors & Fragrances is worth a massive US$12.6b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
International Flavors & Fragrances's debt is 4.0 times its EBITDA, and its EBIT cover its interest expense 5.8 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. If International Flavors & Fragrances can keep growing EBIT at last year's rate of 15% over the last year, then it will find its debt load easier to manage. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine International Flavors & Fragrances's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, International Flavors & Fragrances's free cash flow amounted to 43% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.
International Flavors & Fragrances's net debt to EBITDA was a real negative on this analysis, although the other factors we considered were considerably better There's no doubt that it has an adequate capacity to grow its EBIT. When we consider all the factors mentioned above, we do feel a bit cautious about International Flavors & Fragrances's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of International Flavors & Fragrances's earnings per share history for free.
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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