Rumo (BVMF:RAIL3) Has A Somewhat Strained Balance Sheet

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 the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Rumo

What Is Rumo's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2020 Rumo had R$19.9b of debt, an increase on R$11.7b, over one year. However, because it has a cash reserve of R$10.0b, its net debt is less, at about R$9.91b.

A Look At Rumo's Liabilities

The latest balance sheet data shows that Rumo had liabilities of R$4.86b due within a year, and liabilities of R$25.8b falling due after that. On the other hand, it had cash of R$10.0b and R$956.5m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$19.7b.

This deficit isn't so bad because Rumo is worth R$37.4b, 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.

While Rumo's debt to EBITDA ratio (3.1) suggests that it uses some debt, its interest cover is very weak, at 1.2, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Investors should also be troubled by the fact that Rumo saw its EBIT drop by 15% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Rumo 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Rumo's free cash flow amounted to 38% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say Rumo's interest cover was disappointing. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. Overall, we think it's fair to say that Rumo has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Rumo (1 is a bit unpleasant!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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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