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 Ichor Holdings, Ltd. (NASDAQ:ICHR) does have debt on its balance sheet . But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for Ichor Holdings
What Is Ichor Holdings's Net Debt?
The image below, which you can click on for greater detail, shows that at July 2022 Ichor Holdings had debt of US$304.2m, up from US$166.4m in one year. On the flip side, it has US$46.1m in cash leading to net debt of about US$258.2m.NasdaqGS:ICHR Debt to Equity History September 19th 2022
How Healthy Is Ichor Holdings' Balance Sheet?
We can see from the most recent balance sheet that Ichor Holdings had liabilities of US$198.9m falling due within a year, and liabilities of US$329.5m due beyond that. On the other hand, it had cash of US$46.1m and US$158.4m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$323.9m.
This deficit isn't so bad because Ichor Holdings is worth US$800.7m, 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.
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.
We'd say that Ichor Holdings's moderate net debt to EBITDA ratio ( being 2.2), indicates prudence when it comes to debt. And its commanding EBIT of 13.0 times its interest expense, implies the debt load is as light as a peacock feather. If Ichor Holdings can keep growing EBIT at last year's rate of 10% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Ichor Holdings can strengthen its balance sheet over time. 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. Over the last three years, Ichor Holdings reported free cash flow worth 5.2% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
On our analysis Ichor Holdings's interest cover should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. In particular, conversion of EBIT to free cash flow gives us cold feet. Looking at all this data makes us feel a little cautious about Ichor Holdings's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 2 warning signs we've spotted with Ichor Holdings .
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.