Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We can see that i3 Verticals, Inc. (NASDAQ:IIIV) uses debt in its business. But should shareholders worry about its use of debt?
When is debt dangerous?
Debt helps a business until the business struggles to pay it back, either with new capital or with free cash flow. If things go really bad, lenders can take over the business. 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. Of course, the advantage of debt is that it often represents cheap capital, especially when it replaces dilution in a business with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business has is to look at its cash flow and debt together.
What is i3 Verticals’ net debt?
You can click on the graph below for historical numbers, but it shows that in September 2021, i3 Verticals had debt of US$200.6 million, an increase from US$90.8 million, over a year. And he doesn’t have a lot of cash, so his net debt is about the same.
A look at the passives of i3 Verticals
Zooming in on the latest balance sheet data, we can see that i3 Verticals had liabilities of US$96.5 million due within 12 months and liabilities of US$265.7 million due beyond. On the other hand, it had liquidities of 3.64 million dollars and 38.5 million dollars of receivables within one year. Thus, its liabilities total $320.1 million more than the combination of its cash and short-term receivables.
This shortfall is not that bad as i3 Verticals is worth US$717.6 million and therefore could probably raise enough capital to shore up its balance sheet, should the need arise. But it is clear that it is essential to examine closely whether it can manage its debt without dilution.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (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 ).
A low interest coverage of 0.92x and an extremely high net debt to EBITDA ratio of 7.3 shook our confidence in i3 Verticals like a punch in the gut. The debt burden here is considerable. The good news is that i3 Verticals has grown its EBIT by 30% smoothly over the last twelve months. Like a mother’s loving embrace of a newborn, this kind of growth builds resilience, putting the company in a stronger position to manage its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine i3 Verticals’ 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.
But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, i3 Verticals has actually produced more free cash flow than EBIT. This kind of high cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
Our point of view
We weren’t impressed with i3 Verticals’ net debt to EBITDA ratio, and its interest coverage made us cautious. But like a ballerina finishing on a perfect pirouette, she has no trouble converting EBIT into free cash flow. Given this range of data points, we believe i3 Verticals is in a good position to manage its level of leverage. That said, the charge is heavy enough that we recommend that any shareholder keep a close eye on it. The balance sheet is clearly the area to focus on when analyzing debt. But at the end of the day, every business can contain risks that exist outside of the balance sheet. These risks can be difficult to spot. Every business has them, and we’ve spotted 1 warning sign for i3 Verticals you should know.
If, after all that, you’re more interested in a fast-growing company with a strong balance sheet, check out our list of cash-neutral growth stocks right away.
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