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. 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 Ingersoll-Rand Plc (NYSE:IR) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Ingersoll-Rand's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2019 Ingersoll-Rand had US$5.75b of debt, an increase on US$4.34b, over one year. However, because it has a cash reserve of US$875.6m, its net debt is less, at about US$4.87b.
A Look At Ingersoll-Rand's Liabilities
Zooming in on the latest balance sheet data, we can see that Ingersoll-Rand had liabilities of US$5.18b due within 12 months and liabilities of US$8.31b due beyond that. Offsetting these obligations, it had cash of US$875.6m as well as receivables valued at US$3.17b due within 12 months. So it has liabilities totalling US$9.44b more than its cash and near-term receivables, combined.
Ingersoll-Rand has a very large market capitalization of US$27.9b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With a debt to EBITDA ratio of 2.0, Ingersoll-Rand uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.8 times its interest expenses harmonizes with that theme. If Ingersoll-Rand can keep growing EBIT at last year's rate of 14% 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 Ingersoll-Rand'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, 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. Over the most recent three years, Ingersoll-Rand recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Ingersoll-Rand's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. All these things considered, it appears that Ingersoll-Rand can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. We'd be motivated to research the stock further if we found out that Ingersoll-Rand insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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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.