Yahoo Finance Inchcape (LON:INCH) Takes On Some Risk With Its Use Of Debt
Warren Buffett famously said, 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Inchcape plc (LON:INCH) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
Check out our latest analysis for Inchcape
What Is Inchcape's Debt?
The image below, which you can click on for greater detail, shows that Inchcape had debt of UK£2.06b at the end of June 2019, a reduction from UK£2.61b over a year. On the flip side, it has UK£460.0m in cash leading to net debt of about UK£1.60b.
How Strong Is Inchcape's Balance Sheet?
The latest balance sheet data shows that Inchcape had liabilities of UK£2.66b due within a year, and liabilities of UK£1.01b falling due after that. On the other hand, it had cash of UK£460.0m and UK£634.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£2.58b.
Given this deficit is actually higher than the company's market capitalization of UK£2.52b, we think shareholders really should watch Inchcape's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Inchcape's net debt is 3.8 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 12.9 times its interest expense, implying the company isn't really paying full freight on that debt. Even if not sustainable, that is a good sign. Unfortunately, Inchcape saw its EBIT slide 8.5% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Inchcape'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Inchcape produced sturdy free cash flow equating to 60% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Our View
Inchcape's level of total liabilities and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. Taking the abovementioned factors together we do think Inchcape's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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.
