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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that RKEC Projects Limited (NSE:RKEC) does have debt on its balance sheet. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
Check out our latest analysis for RKEC Projects
What Is RKEC Projects's Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2022 RKEC Projects had ₹1.24b of debt, an increase on ₹1.15b, over one year. However, because it has a cash reserve of ₹326.6m, its net debt is less, at about ₹915.1m.
How Strong Is RKEC Projects' Balance Sheet?
We can see from the most recent balance sheet that RKEC Projects had liabilities of ₹1.41b falling due within a year, and liabilities of ₹555.3m due beyond that. On the other hand, it had cash of ₹326.6m and ₹1.50b worth of receivables due within a year. So it has liabilities totalling ₹139.1m more than its cash and near-term receivables, combined.
Given RKEC Projects has a market capitalization of ₹1.61b, it's hard to believe these liabilities pose much threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
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).
RKEC Projects's debt is 3.2 times its EBITDA, and its EBIT cover its interest expense 3.8 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Even more troubling is the fact that RKEC Projects actually let its EBIT decrease by 9.9% over the last year. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. The balance sheet is clearly the area to focus on when you are analysing debt. But it is RKEC Projects's earnings that will influence how the balance sheet holds up in the future. 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.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, RKEC Projects burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.
Our View
Mulling over RKEC Projects's attempt at converting EBIT to free cash flow, we're certainly not enthusiastic. But at least it's pretty decent at staying on top of its total liabilities; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making RKEC Projects stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for RKEC Projects (of which 3 shouldn't be ignored!) you should know about.
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.
About NSEI:RKEC
RKEC Projects
A construction company, engages in the civil and defense constructions business in India.
Proven track record with mediocre balance sheet.