Is RPM Automotive Group (ASX:RPM) A Risky Investment?

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.' 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. As with many other companies RPM Automotive Group Limited (ASX:RPM) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for RPM Automotive Group

How Much Debt Does RPM Automotive Group Carry?

As you can see below, at the end of December 2020, RPM Automotive Group had AU$6.82m of debt, up from AU$5.30m a year ago. Click the image for more detail. However, it also had AU$3.98m in cash, and so its net debt is AU$2.84m.

How Strong Is RPM Automotive Group's Balance Sheet?

We can see from the most recent balance sheet that RPM Automotive Group had liabilities of AU$10.6m falling due within a year, and liabilities of AU$5.23m due beyond that. Offsetting these obligations, it had cash of AU$3.98m as well as receivables valued at AU$5.32m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$6.48m.

Of course, RPM Automotive Group has a market capitalization of AU$38.3m, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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.

While RPM Automotive Group's low debt to EBITDA ratio of 1.1 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 5.4 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. We also note that RPM Automotive Group improved its EBIT from a last year's loss to a positive AU$2.4m. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since RPM Automotive Group will need earnings to service that debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Considering the last year, RPM Automotive Group actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

RPM Automotive Group's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to handle its debt, based on its EBITDA, isn't too shabby at all. We think that RPM Automotive Group's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 3 warning signs with RPM Automotive Group , and understanding them should be part of your investment process.

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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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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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