Does Reliance Worldwide (ASX:RWC) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Reliance Worldwide Corporation Limited (ASX:RWC) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Reliance Worldwide

What Is Reliance Worldwide's Debt?

The chart below, which you can click on for greater detail, shows that Reliance Worldwide had US$566.6m in debt in December 2022; about the same as the year before. However, it does have US$34.9m in cash offsetting this, leading to net debt of about US$531.7m.

How Healthy Is Reliance Worldwide's Balance Sheet?

According to the last reported balance sheet, Reliance Worldwide had liabilities of US$195.0m due within 12 months, and liabilities of US$746.9m due beyond 12 months. Offsetting this, it had US$34.9m in cash and US$266.8m in receivables that were due within 12 months. So its liabilities total US$640.2m more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Reliance Worldwide is worth US$1.92b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

With a debt to EBITDA ratio of 2.1, Reliance Worldwide uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.5 times interest expense) certainly does not do anything to dispel this impression. Notably Reliance Worldwide's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Reliance Worldwide can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Reliance Worldwide produced sturdy free cash flow equating to 56% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Reliance Worldwide's interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. On the other hand, its net debt to EBITDA makes us a little less comfortable about its debt. When we consider all the factors mentioned above, we do feel a bit cautious about Reliance Worldwide's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Reliance Worldwide you should know about.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.