Warren Buffett said: “Volatility is far from synonymous with risk. When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Mostly, InvoCare Limited (ASX:IVC) is in debt. But the more important question is: what risk does this debt create?
When is debt dangerous?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. Ultimately, if the company cannot meet its legal debt repayment obligations, shareholders could walk away with nothing. However, a more common (but still costly) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. When we look at debt levels, we first consider cash and debt levels, together.
See our latest analysis for InvoCare
What is InvoCare’s debt?
The image below, which you can click on for more details, shows that InvoCare had A$188.9 million in debt at the end of December 2021, a reduction from A$247.2 million over a year. On the other hand, he has A$53.6 million in cash, resulting in a net debt of around A$135.3 million.
How strong is InvoCare’s balance sheet?
The latest balance sheet data shows that InvoCare had liabilities of A$197.6 million due within one year, and liabilities of A$978.6 million falling due thereafter. As compensation for these obligations, it had cash of A$53.6 million as well as receivables valued at A$57.2 million and due within 12 months. Thus, its liabilities outweigh the sum of its cash and (short-term) receivables of A$1.07 billion.
This is a mountain of leverage compared to its market capitalization of AU$1.72 billion. If its lenders asked it to shore up its balance sheet, shareholders would likely face significant dilution.
In order to assess a company’s debt relative to its earnings, we calculate its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and its earnings before interest and taxes (EBIT) divided by its expenses. interest (its interest coverage). The advantage of this approach is that we consider both the absolute amount of debt (with net debt to EBITDA) and the actual interest expense associated with that debt (with its interest coverage ratio ).
Given that net debt is only 1.3x EBITDA, it is initially surprising to see that InvoCare’s EBIT has a low interest coverage of 2.1x. So either way, it’s clear that debt levels are not negligible. Importantly, InvoCare has grown its EBIT by 66% over the last twelve months, and this growth will make it easier to manage its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But future revenues, more than anything, will determine InvoCare’s ability to maintain a healthy balance sheet in the future. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, while the taxman may love accounting profits, lenders only accept cash. So the logical step is to look at what proportion of that EBIT is actual free cash flow. Over the past three years, InvoCare has nearly broken even on a free cash flow basis. Some might say that’s a concern, given how easily he could reduce his debt.
Our point of view
InvoCare’s interest coverage and conversion of EBIT to free cash flow is certainly weighing on it, in our view. But the good news is that it looks like it could easily increase its EBIT. We think InvoCare’s debt makes it a bit risky, after looking at the aforementioned data points together. Not all risk is bad, as it can increase stock price returns if it pays off, but this leverage risk is worth keeping in mind. There is no doubt that we learn the most about debt from the balance sheet. But at the end of the day, every business can contain risks that exist outside of the balance sheet. To this end, you should be aware of the 1 warning sign we spotted with InvoCare.
In the end, it’s often best to focus on companies that aren’t in debt. You can access our special list of these companies (all with a track record of earnings growth). It’s free.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
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