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.' 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, RCM Technologies, Inc. (NASDAQ:RCMT) does carry debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
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. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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 RCM Technologies's Net Debt?
As you can see below, at the end of March 2019, RCM Technologies had US$34.4m of debt, up from US$29.2m a year ago. Click the image for more detail. However, because it has a cash reserve of US$1.69m, its net debt is less, at about US$32.7m.
A Look At RCM Technologies's Liabilities
We can see from the most recent balance sheet that RCM Technologies had liabilities of US$21.3m falling due within a year, and liabilities of US$42.5m due beyond that. Offsetting this, it had US$1.69m in cash and US$49.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$12.2m.
While this might seem like a lot, it is not so bad since RCM Technologies has a market capitalization of US$42.8m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
RCM Technologies has a debt to EBITDA ratio of 3.9 and its EBIT covered its interest expense 4.7 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Sadly, RCM Technologies's EBIT actually dropped 4.1% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if RCM Technologies can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, RCM Technologies created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.
While RCM Technologies's conversion of EBIT to free cash flow makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. At least its level of total liabilities gives us reason to be optimistic. Taking the abovementioned factors together we do think RCM Technologies's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.