Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ 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 Rapala VMC Corporation (HEL:RAP1V) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can’t easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, 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. When we think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Rapala VMC Carry?
The chart below, which you can click on for greater detail, shows that Rapala VMC had €82.2m in debt in December 2019; about the same as the year before. However, it does have €12.6m in cash offsetting this, leading to net debt of about €69.6m.
How Healthy Is Rapala VMC’s Balance Sheet?
We can see from the most recent balance sheet that Rapala VMC had liabilities of €74.4m falling due within a year, and liabilities of €63.6m due beyond that. On the other hand, it had cash of €12.6m and €48.6m worth of receivables due within a year. So it has liabilities totalling €76.8m more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of €100.2m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Rapala VMC has net debt to EBITDA of 3.3 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 8.8 suggests it can easily service that debt. Unfortunately, Rapala VMC saw its EBIT slide 6.3% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Rapala VMC 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Rapala VMC recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
When it comes to the balance sheet, the standout positive for Rapala VMC was the fact that it seems able to convert EBIT to free cash flow confidently. However, our other observations weren’t so heartening. For instance it seems like it has to struggle a bit to handle its total liabilities. Looking at all this data makes us feel a little cautious about Rapala VMC’s debt levels. While we appreciate debt can enhance returns on equity, we’d suggest that shareholders keep close watch on its debt levels, lest they increase. 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 Rapala VMC is showing 1 warning sign in our investment analysis , you should know about…
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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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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