Here's Why Rumo (BVMF:RAIL3) Has A Meaningful Debt Burden

By
Simply Wall St
Published
July 25, 2021
BOVESPA:RAIL3
Source: Shutterstock

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.' 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. We can see that Rumo S.A. (BVMF:RAIL3) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Rumo

What Is Rumo's Debt?

The image below, which you can click on for greater detail, shows that at March 2021 Rumo had debt of R$15.6b, up from R$14.8b in one year. However, because it has a cash reserve of R$5.63b, its net debt is less, at about R$9.96b.

debt-equity-history-analysis
BOVESPA:RAIL3 Debt to Equity History July 25th 2021

How Strong Is Rumo's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Rumo had liabilities of R$3.69b due within 12 months and liabilities of R$22.4b due beyond that. Offsetting these obligations, it had cash of R$5.63b as well as receivables valued at R$1.08b due within 12 months. So it has liabilities totalling R$19.3b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Rumo has a market capitalization of R$39.6b, 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Rumo's debt to EBITDA ratio (3.0) suggests that it uses some debt, its interest cover is very weak, at 1.1, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Given the debt load, it's hardly ideal that Rumo's EBIT was pretty flat over the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Rumo's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

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. Looking at the most recent three years, Rumo recorded free cash flow of 32% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Rumo's interest cover was disappointing. Having said that, its ability to grow its EBIT isn't such a worry. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Rumo stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. To that end, you should learn about the 2 warning signs we've spotted with Rumo (including 1 which is potentially serious) .

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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