These 4 Measures Indicate That Rumo (BVMF:RAIL3) Is Using Debt Extensively

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 Rumo S.A. (BVMF:RAIL3) 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. If things get really bad, the lenders can take control of the business. 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 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 Rumo

What Is Rumo's Debt?

As you can see below, at the end of September 2020, Rumo had R$21.1b of debt, up from R$10.9b a year ago. Click the image for more detail. However, it also had R$10.2b in cash, and so its net debt is R$10.9b.

How Healthy Is Rumo's Balance Sheet?

According to the last reported balance sheet, Rumo had liabilities of R$4.38b due within 12 months, and liabilities of R$26.9b due beyond 12 months. On the other hand, it had cash of R$10.2b and R$1.02b worth of receivables due within a year. So it has liabilities totalling R$20.1b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Rumo is worth R$34.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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). 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).

While Rumo's debt to EBITDA ratio (3.3) 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. More concerning, Rumo saw its EBIT drop by 9.0% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. There's no doubt that we learn most about debt from the balance sheet. 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 company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Rumo's free cash flow amounted to 43% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Rumo's attempt at covering its interest expense with its EBIT, we're certainly not enthusiastic. 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 everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Be aware that Rumo is showing 3 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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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