Rumo (BVMF:RAIL3) Has A Somewhat Strained Balance Sheet

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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. We can see that Rumo S.A. (BVMF:RAIL3) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Rumo

What Is Rumo's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2020 Rumo had R$17.9b of debt, an increase on R$10.7b, over one year. However, it also had R$5.88b in cash, and so its net debt is R$12.0b.

How Healthy Is Rumo's Balance Sheet?

The latest balance sheet data shows that Rumo had liabilities of R$4.79b due within a year, and liabilities of R$28.4b falling due after that. Offsetting these obligations, it had cash of R$5.88b as well as receivables valued at R$937.8m due within 12 months. So its liabilities total R$26.3b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of R$35.2b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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).

While we wouldn't worry about Rumo's net debt to EBITDA ratio of 3.5, we think its super-low interest cover of 1.4 times is a sign of high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. The good news is that Rumo improved its EBIT by 5.1% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Rumo'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 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, Rumo's free cash flow amounted to 39% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Rumo's interest cover was disappointing. But at least its EBIT growth rate is not so bad. Once we consider all the factors above, together, it seems to us that Rumo's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Case in point: We've spotted 2 warning signs for Rumo you should be aware of, and 1 of them shouldn't be ignored.

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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