Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, RTC Group plc (LON:RTC) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is RTC Group's Debt?
You can click the graphic below for the historical numbers, but it shows that RTC Group had UK£4.05m of debt in June 2019, down from UK£6.03m, one year before. However, it does have UK£92.0k in cash offsetting this, leading to net debt of about UK£3.96m.
A Look At RTC Group's Liabilities
The latest balance sheet data shows that RTC Group had liabilities of UK£11.0m due within a year, and liabilities of UK£3.02m falling due after that. On the other hand, it had cash of UK£92.0k and UK£14.3m worth of receivables due within a year. So it can boast UK£339.0k more liquid assets than total liabilities.
This short term liquidity is a sign that RTC Group could probably pay off its debt with ease, as its balance sheet is far from stretched.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
We'd say that RTC Group's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its strong interest cover of 12.7 times, makes us even more comfortable. It is well worth noting that RTC Group's EBIT shot up like bamboo after rain, gaining 34% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is RTC Group's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, RTC Group's free cash flow amounted to 38% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
The good news is that RTC Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. Zooming out, RTC Group seems to use debt quite reasonably; and that gets the nod from us. While debt does bring risk, when used wisely it can also bring a higher return on equity. Given RTC 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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