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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.' 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 RBC Bearings Incorporated (NASDAQ:ROLL) does use debt in its business. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.
What Is RBC Bearings's Debt?
The image below, which you can click on for greater detail, shows that RBC Bearings had debt of US$20.5m at the end of December 2020, a reduction from US$22.8m over a year. However, its balance sheet shows it holds US$201.7m in cash, so it actually has US$181.2m net cash.
How Strong Is RBC Bearings' Balance Sheet?
Zooming in on the latest balance sheet data, we can see that RBC Bearings had liabilities of US$88.4m due within 12 months and liabilities of US$115.8m due beyond that. Offsetting this, it had US$201.7m in cash and US$108.6m in receivables that were due within 12 months. So it actually has US$106.2m more liquid assets than total liabilities.
This short term liquidity is a sign that RBC Bearings could probably pay off its debt with ease, as its balance sheet is far from stretched. Succinctly put, RBC Bearings boasts net cash, so it's fair to say it does not have a heavy debt load!
On the other hand, RBC Bearings's EBIT dived 15%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 RBC Bearings'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. RBC Bearings may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, RBC Bearings produced sturdy free cash flow equating to 73% 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.
While it is always sensible to investigate a company's debt, in this case RBC Bearings has US$181.2m in net cash and a decent-looking balance sheet. The cherry on top was that in converted 73% of that EBIT to free cash flow, bringing in US$136m. So we are not troubled with RBC Bearings's debt use. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 1 warning sign for RBC Bearings you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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. 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.
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