Here's Why RHI Magnesita (LON:RHIM) Has A Meaningful Debt Burden

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that RHI Magnesita N.V. (LON:RHIM) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for RHI Magnesita

How Much Debt Does RHI Magnesita Carry?

You can click the graphic below for the historical numbers, but it shows that RHI Magnesita had €1.04b of debt in June 2021, down from €1.14b, one year before. However, because it has a cash reserve of €333.0m, its net debt is less, at about €703.5m.

How Healthy Is RHI Magnesita's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that RHI Magnesita had liabilities of €1.01b due within 12 months and liabilities of €1.44b due beyond that. Offsetting these obligations, it had cash of €333.0m as well as receivables valued at €468.1m due within 12 months. So its liabilities total €1.65b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of €2.08b, so it does suggest shareholders should keep an eye on RHI Magnesita's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). 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).

RHI Magnesita's net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its strong interest cover of 10.2 times, makes us even more comfortable. The bad news is that RHI Magnesita saw its EBIT decline by 13% over the last year. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. 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 RHI Magnesita 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, RHI Magnesita produced sturdy free cash flow equating to 58% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

RHI Magnesita's EBIT growth rate and level of total liabilities definitely weigh on it, in our esteem. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. When we consider all the factors discussed, it seems to us that RHI Magnesita is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example RHI Magnesita has 3 warning signs (and 1 which is a bit concerning) we think 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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