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 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. Importantly, Russel Metals Inc. (TSE:RUS) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Russel Metals's Net Debt?
As you can see below, Russel Metals had CA$579.6m of debt, at June 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have CA$98.1m in cash offsetting this, leading to net debt of about CA$481.5m.
A Look At Russel Metals's Liabilities
We can see from the most recent balance sheet that Russel Metals had liabilities of CA$558.0m falling due within a year, and liabilities of CA$577.7m due beyond that. Offsetting these obligations, it had cash of CA$98.1m as well as receivables valued at CA$543.5m due within 12 months. So its liabilities total CA$494.1m more than the combination of its cash and short-term receivables.
While this might seem like a lot, it is not so bad since Russel Metals has a market capitalization of CA$1.35b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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).
Russel Metals's net debt of 1.5 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.4 times interest expense) certainly does not do anything to dispel this impression. The good news is that Russel Metals has increased its EBIT by 6.4% over twelve months, which should ease any concerns about debt repayment. 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 Russel Metals 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Russel Metals reported free cash flow worth 7.4% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
Russel Metals's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to cover its interest expense with its EBIT isn't too shabby at all. We think that Russel Metals's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.