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. We can see that Installed Building Products, Inc. (NYSE:IBP) does use debt in its business. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. 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.
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What Is Installed Building Products’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2022 Installed Building Products had US$858.4m of debt, an increase on US$567.1m, over one year. However, it also had US$228.4m in cash, and so its net debt is US$630.0m.
How Strong Is Installed Building Products’ Balance Sheet?
According to the last reported balance sheet, Installed Building Products had liabilities of US$358.6m due within 12 months, and liabilities of US$947.8m due beyond 12 months. On the other hand, it had cash of US$228.4m and US$453.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$624.3m.
Installed Building Products has a market capitalization of US$2.25b, 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.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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).
Installed Building Products’s net debt of 1.6 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.1 times interest expense) certainly does not do anything to dispel this impression. In addition to that, we’re happy to report that Installed Building Products has boosted its EBIT by 58%, thus reducing the spectre of future debt repayments. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Installed Building Products’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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Installed Building Products produced sturdy free cash flow equating to 65% 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.
Installed Building Products’s EBIT growth rate 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. Taking all this data into account, it seems to us that Installed Building Products takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we’ve spotted with Installed Building Products (including 1 which is a bit concerning) .
If you’re interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.