Here's Why Rane Engine Valve (NSE:RANEENGINE) Has A Meaningful Debt Burden

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 can see that Rane Engine Valve Limited (NSE:RANEENGINE) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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 examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Rane Engine Valve

What Is Rane Engine Valve's Net Debt?

As you can see below, at the end of March 2023, Rane Engine Valve had ₹1.36b of debt, up from ₹1.28b a year ago. Click the image for more detail. However, it also had ₹79.9m in cash, and so its net debt is ₹1.28b.

How Strong Is Rane Engine Valve's Balance Sheet?

According to the last reported balance sheet, Rane Engine Valve had liabilities of ₹1.85b due within 12 months, and liabilities of ₹618.2m due beyond 12 months. Offsetting these obligations, it had cash of ₹79.9m as well as receivables valued at ₹1.08b due within 12 months. So its liabilities total ₹1.31b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Rane Engine Valve has a market capitalization of ₹2.22b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

While Rane Engine Valve's debt to EBITDA ratio (3.5) suggests that it uses some debt, its interest cover is very weak, at 1.7, suggesting high leverage. In large part that's due to the company's significant depreciation and amortisation charges, which arguably mean its EBITDA is a very generous measure of earnings, and its debt may be more of a burden than it first appears. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. However, the silver lining was that Rane Engine Valve achieved a positive EBIT of ₹169m in the last twelve months, an improvement on the prior year's loss. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Rane Engine Valve will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, Rane Engine Valve reported free cash flow worth 2.5% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Rane Engine Valve's conversion of EBIT to free cash flow left us tentative about the stock, and its interest cover was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. Looking at the bigger picture, it seems clear to us that Rane Engine Valve's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Rane Engine Valve (1 is a bit concerning) you should be aware of.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.