Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘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. Importantly, Ingredion Incorporated (NYSE:INGR) does carry debt. But the more important question is: how much risk is that debt creating?
What Risk Does Debt Bring?
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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Ingredion’s Debt?
You can click the graphic below for the historical numbers, but it shows that as of June 2022 Ingredion had US$2.39b of debt, an increase on US$2.20b, over one year. However, because it has a cash reserve of US$322.0m, its net debt is less, at about US$2.07b.
How Strong Is Ingredion’s Balance Sheet?
The latest balance sheet data shows that Ingredion had liabilities of US$1.85b due within a year, and liabilities of US$2.31b falling due after that. Offsetting this, it had US$322.0m in cash and US$1.29b in receivables that were due within 12 months. So it has liabilities totalling US$2.55b more than its cash and near-term receivables, combined.
This deficit isn’t so bad because Ingredion is worth US$5.25b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without dilution.
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). 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 2.3, Ingredion uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.1 times its interest expenses harmonizes with that theme. Sadly, Ingredion’s EBIT actually dropped 8.5% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Ingredion can strengthen its balance sheet over time.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Ingredion recorded free cash flow of 32% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
Ingredion’s EBIT growth rate and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But it seems to be able to cover its interest expense with its EBIT without much trouble. When we consider all the factors discussed, it seems to us that Ingredion is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn’t really want to see it increase from here. When analysing debt levels, the balance sheet is the obvious place to start.