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. 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. As with many other companies RITES Limited (NSE:RITES) makes use of debt. But should shareholders be worried about its use of debt?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does RITES Carry?
You can click the graphic below for the historical numbers, but it shows that RITES had ₹366.5m of debt in September 2019, down from ₹530.9m, one year before. But it also has ₹36.0b in cash to offset that, meaning it has ₹35.6b net cash.
How Healthy Is RITES’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that RITES had liabilities of ₹26.7b due within 12 months and liabilities of ₹2.06b due beyond that. Offsetting this, it had ₹36.0b in cash and ₹9.79b in receivables that were due within 12 months. So it actually has ₹17.0b more liquid assets than total liabilities.
This excess liquidity suggests that RITES is taking a careful approach to debt. Due to its strong net asset position, it is not likely to face issues with its lenders. Succinctly put, RITES boasts net cash, so it’s fair to say it does not have a heavy debt load!
In addition to that, we’re happy to report that RITES has boosted its EBIT by 35%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is RITES’s earnings that will influence how the balance sheet holds up in the future. So when considering debt, it’s definitely worth looking at the earnings trend. Click here for an interactive snapshot.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. While RITES has net cash on its balance sheet, it’s still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Looking at the most recent three years, RITES recorded free cash flow of 34% of its EBIT, which is weaker than we’d expect. That’s not great, when it comes to paying down debt.
While it is always sensible to investigate a company’s debt, in this case RITES has ₹35.6b in net cash and a decent-looking balance sheet. And it impressed us with its EBIT growth of 35% over the last year. So is RITES’s debt a risk? It doesn’t seem so to us. There’s no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we’ve discovered 2 warning signs for RITES that you should be aware of before investing here.
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.
If you spot an error that warrants correction, please contact the editor at email@example.com. 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.
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