Rectifier Technologies (ASX:RFT) Seems To Use Debt Quite Sensibly

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. We can see that Rectifier Technologies Limited (ASX:RFT) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Rectifier Technologies

What Is Rectifier Technologies's Debt?

As you can see below, Rectifier Technologies had AU$2.50m of debt at December 2020, down from AU$2.75m a year prior. But it also has AU$5.49m in cash to offset that, meaning it has AU$2.99m net cash.

How Strong Is Rectifier Technologies' Balance Sheet?

The latest balance sheet data shows that Rectifier Technologies had liabilities of AU$2.84m due within a year, and liabilities of AU$3.71m falling due after that. Offsetting these obligations, it had cash of AU$5.49m as well as receivables valued at AU$1.87m due within 12 months. So it actually has AU$804.9k more liquid assets than total liabilities.

This state of affairs indicates that Rectifier Technologies' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So it's very unlikely that the AU$42.6m company is short on cash, but still worth keeping an eye on the balance sheet. Succinctly put, Rectifier Technologies boasts net cash, so it's fair to say it does not have a heavy debt load!

The modesty of its debt load may become crucial for Rectifier Technologies if management cannot prevent a repeat of the 56% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is Rectifier Technologies'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. Rectifier Technologies may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. During the last three years, Rectifier Technologies produced sturdy free cash flow equating to 59% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Summing up

While it is always sensible to investigate a company's debt, in this case Rectifier Technologies has AU$2.99m in net cash and a decent-looking balance sheet. So we don't have any problem with Rectifier Technologies's use of debt. 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. For instance, we've identified 2 warning signs for Rectifier Technologies that you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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