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. 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 Reading International, Inc. (NASDAQ:RDI) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, 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.
How Much Debt Does Reading International Carry?
The image below, which you can click on for greater detail, shows that at June 2019 Reading International had debt of US$183.6m, up from US$164.2m in one year. However, it does have US$8.80m in cash offsetting this, leading to net debt of about US$174.8m.
How Healthy Is Reading International's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Reading International had liabilities of US$109.1m due within 12 months and liabilities of US$386.0m due beyond that. Offsetting these obligations, it had cash of US$8.80m as well as receivables valued at US$13.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$472.6m.
This deficit casts a shadow over the US$284.9m company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Reading International would probably need a major re-capitalization if its creditors were to demand repayment.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
While Reading International's debt to EBITDA ratio (4.2) suggests that it uses some debt, its interest cover is very weak, at 2.4, suggesting high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Even more troubling is the fact that Reading International actually let its EBIT decrease by 5.0% over the last year. If that earnings trend continues the company will face an uphill battle to pay off its debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Reading International's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Reading International burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
To be frank both Reading International's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. And furthermore, its net debt to EBITDA also fails to instill confidence. Taking into account all the aforementioned factors, it looks like Reading International has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. Given the risks around Reading International's use of debt, the sensible thing to do is to check if insiders have been unloading the stock.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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