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 note that Ridley Corporation Limited (ASX:RIC) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Ridley Carry?
You can click the graphic below for the historical numbers, but it shows that Ridley had AU$156.9m of debt in December 2020, down from AU$222.4m, one year before. However, it also had AU$35.2m in cash, and so its net debt is AU$121.7m.
How Healthy Is Ridley's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Ridley had liabilities of AU$183.4m due within 12 months and liabilities of AU$172.4m due beyond that. Offsetting this, it had AU$35.2m in cash and AU$119.1m in receivables that were due within 12 months. So it has liabilities totalling AU$201.6m more than its cash and near-term receivables, combined.
This deficit isn't so bad because Ridley is worth AU$365.8m, 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a debt to EBITDA ratio of 1.8, Ridley uses debt artfully but responsibly. And the alluring interest cover (EBIT of 7.9 times interest expense) certainly does not do anything to dispel this impression. Notably, Ridley's EBIT launched higher than Elon Musk, gaining a whopping 191% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Ridley can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Ridley saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
Neither Ridley's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. We think that Ridley's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 5 warning signs for Ridley that you should be aware of before investing here.
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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