We Think RSWM (NSE:RSWM) Is Taking Some Risk With Its Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that RSWM Limited (NSE:RSWM) does have debt on its balance sheet. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for RSWM

What Is RSWM's Net Debt?

As you can see below, RSWM had ₹8.81b of debt at September 2021, down from ₹10.5b a year prior. Net debt is about the same, since the it doesn't have much cash.

How Strong Is RSWM's Balance Sheet?

We can see from the most recent balance sheet that RSWM had liabilities of ₹9.22b falling due within a year, and liabilities of ₹3.63b due beyond that. Offsetting this, it had ₹50.7m in cash and ₹4.15b in receivables that were due within 12 months. So it has liabilities totalling ₹8.64b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of ₹11.3b, so it does suggest shareholders should keep an eye on RSWM's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

RSWM has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 4.8 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Notably, RSWM made a loss at the EBIT level, last year, but improved that to positive EBIT of ₹2.7b in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is RSWM's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. In the last year, RSWM's free cash flow amounted to 32% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

While RSWM's conversion of EBIT to free cash flow makes us cautious about it, its track record of staying on top of its total liabilities is no better. At least its EBIT growth rate gives us reason to be optimistic. Taking the abovementioned factors together we do think RSWM's debt poses some risks to the business. 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, we've discovered 2 warning signs for RSWM that you should be aware of before investing here.

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.