Rain Industries (NSE:RAIN) Takes On Some Risk With Its Use Of Debt

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.' 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 Rain Industries Limited (NSE:RAIN) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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 Rain Industries

What Is Rain Industries's Debt?

The image below, which you can click on for greater detail, shows that Rain Industries had debt of ₹79.2b at the end of June 2021, a reduction from ₹87.7b over a year. However, because it has a cash reserve of ₹16.5b, its net debt is less, at about ₹62.7b.

How Healthy Is Rain Industries' Balance Sheet?

According to the last reported balance sheet, Rain Industries had liabilities of ₹27.1b due within 12 months, and liabilities of ₹98.9b due beyond 12 months. Offsetting this, it had ₹16.5b in cash and ₹15.9b in receivables that were due within 12 months. So it has liabilities totalling ₹93.6b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's ₹74.7b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Rain Industries has a debt to EBITDA ratio of 3.0 and its EBIT covered its interest expense 3.1 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that Rain Industries grew its EBIT a smooth 37% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Rain Industries'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 it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Rain Industries produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

While Rain Industries's level of total liabilities has us nervous. For example, its EBIT growth rate and conversion of EBIT to free cash flow give us some confidence in its ability to manage its debt. We think that Rain Industries's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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 3 warning signs for Rain Industries (1 can't be ignored!) that you should be aware of before investing here.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.
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