Does Royal Mail (LON:RMG) Have A Healthy Balance Sheet?

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Royal Mail plc (LON:RMG) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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.

View our latest analysis for Royal Mail

What Is Royal Mail's Debt?

The chart below, which you can click on for greater detail, shows that Royal Mail had UK£872.0m in debt in March 2022; about the same as the year before. However, its balance sheet shows it holds UK£1.21b in cash, so it actually has UK£335.0m net cash.

A Look At Royal Mail's Liabilities

According to the last reported balance sheet, Royal Mail had liabilities of UK£2.74b due within 12 months, and liabilities of UK£2.61b due beyond 12 months. On the other hand, it had cash of UK£1.21b and UK£1.59b worth of receivables due within a year. So its liabilities total UK£2.54b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of UK£2.55b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Despite its noteworthy liabilities, Royal Mail boasts net cash, so it's fair to say it does not have a heavy debt load!

But the bad news is that Royal Mail has seen its EBIT plunge 11% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Royal Mail's ability to maintain a healthy balance sheet going forward. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. While Royal Mail has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last three years, Royal Mail recorded free cash flow worth a fulsome 94% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Summing Up

Although Royal Mail's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£335.0m. The cherry on top was that in converted 94% of that EBIT to free cash flow, bringing in UK£557m. So we are not troubled with Royal Mail's debt use. 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. Be aware that Royal Mail is showing 2 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.