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.' 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 note that The Rank Group Plc (LON:RNK) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
What Is Rank Group's Net Debt?
The image below, which you can click on for greater detail, shows that Rank Group had debt of UK£53.2m at the end of June 2019, a reduction from UK£59.7m over a year. However, it does have UK£61.8m in cash offsetting this, leading to net cash of UK£8.60m.
How Strong Is Rank Group's Balance Sheet?
The latest balance sheet data shows that Rank Group had liabilities of UK£222.0m due within a year, and liabilities of UK£89.3m falling due after that. On the other hand, it had cash of UK£61.8m and UK£27.8m worth of receivables due within a year. So it has liabilities totalling UK£221.7m more than its cash and near-term receivables, combined.
Rank Group has a market capitalization of UK£664.9m, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk. Despite its noteworthy liabilities, Rank Group boasts net cash, so it's fair to say it does not have a heavy debt load!
But the other side of the story is that Rank Group saw its EBIT decline by 5.8% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Rank Group'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 company can only pay off debt with cold hard cash, not accounting profits. Rank Group 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. Over the most recent three years, Rank Group recorded free cash flow worth 73% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Although Rank Group's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£8.6m. The cherry on top was that in converted 73% of that EBIT to free cash flow, bringing in UK£66m. So we are not troubled with Rank Group's debt use. Given Rank Group has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
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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