Is Rallye (EPA:RAL) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Rallye SA (EPA:RAL) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

See our latest analysis for Rallye

What Is Rallye's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Rallye had €10.3b of debt in December 2021, down from €11.1b, one year before. However, because it has a cash reserve of €2.16b, its net debt is less, at about €8.14b.

A Look At Rallye's Liabilities

Zooming in on the latest balance sheet data, we can see that Rallye had liabilities of €11.9b due within 12 months and liabilities of €15.8b due beyond that. Offsetting these obligations, it had cash of €2.16b as well as receivables valued at €1.06b due within 12 months. So it has liabilities totalling €24.5b more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the €172.5m company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Rallye would probably need a major re-capitalization if its creditors were to demand repayment.

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.

Weak interest cover of 1.1 times and a disturbingly high net debt to EBITDA ratio of 7.8 hit our confidence in Rallye like a one-two punch to the gut. The debt burden here is substantial. Worse, Rallye's EBIT was down 63% over the last year. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Rallye will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Rallye's free cash flow amounted to 40% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both Rallye's EBIT growth rate and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. Considering all the factors previously mentioned, we think that Rallye really is carrying too much debt. To our minds, that means the stock is rather high risk, and probably one to avoid; but to each their own (investing) style. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 1 warning sign with Rallye , and understanding them should be part of your investment process.

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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.