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. 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. As with many other companies Redcentric plc (LON:RCN) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Redcentric Carry?
You can click the graphic below for the historical numbers, but it shows that Redcentric had UK£12.7m of debt in September 2019, down from UK£24.4m, one year before. However, it also had UK£2.18m in cash, and so its net debt is UK£10.5m.
How Healthy Is Redcentric’s Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Redcentric had liabilities of UK£24.5m due within 12 months and liabilities of UK£38.5m due beyond that. Offsetting this, it had UK£2.18m in cash and UK£13.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£47.1m.
While this might seem like a lot, it is not so bad since Redcentric has a market capitalization of UK£148.8m, 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).
Given net debt is only 0.73 times EBITDA, it is initially surprising to see that Redcentric’s EBIT has low interest coverage of 0.77 times. So while we’re not necessarily alarmed we think that its debt is far from trivial. We note that Redcentric grew its EBIT by 27% in the last year, and that should make it easier to pay down debt, going forward. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Redcentric’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 it’s worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Redcentric actually produced more free cash flow than EBIT over the last three years. There’s nothing better than incoming cash when it comes to staying in your lenders’ good graces.
Happily, Redcentric’s impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But the stark truth is that we are concerned by its interest cover. Taking all this data into account, it seems to us that Redcentric takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. We’d be motivated to research the stock further if we found out that Redcentric insiders have bought shares recently. If you would too, then you’re in luck, since today we’re sharing our list of reported insider transactions for free.
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.
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.
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. Thank you for reading.