Is Rashtriya Chemicals and Fertilizers (NSE:RCF) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies Rashtriya Chemicals and Fertilizers Limited (NSE:RCF) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

Check out our latest analysis for Rashtriya Chemicals and Fertilizers

How Much Debt Does Rashtriya Chemicals and Fertilizers Carry?

As you can see below, Rashtriya Chemicals and Fertilizers had ₹23.0b of debt at September 2023, down from ₹30.8b a year prior. However, it also had ₹22.6b in cash, and so its net debt is ₹385.2m.

How Strong Is Rashtriya Chemicals and Fertilizers' Balance Sheet?

According to the last reported balance sheet, Rashtriya Chemicals and Fertilizers had liabilities of ₹34.1b due within 12 months, and liabilities of ₹18.5b due beyond 12 months. Offsetting these obligations, it had cash of ₹22.6b as well as receivables valued at ₹9.79b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₹20.3b.

While this might seem like a lot, it is not so bad since Rashtriya Chemicals and Fertilizers has a market capitalization of ₹77.8b, 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. Carrying virtually no net debt, Rashtriya Chemicals and Fertilizers has a very light debt load indeed.

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

With net debt at just 0.063 times EBITDA, it seems Rashtriya Chemicals and Fertilizers only uses a little bit of leverage. Although with EBIT only covering interest expenses 2.6 times over, the company is truly paying for borrowing. Shareholders should be aware that Rashtriya Chemicals and Fertilizers's EBIT was down 73% last year. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Rashtriya Chemicals and Fertilizers will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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. Over the last three years, Rashtriya Chemicals and Fertilizers actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Based on what we've seen Rashtriya Chemicals and Fertilizers is not finding it easy, given its EBIT growth rate, but the other factors we considered give us cause to be optimistic. In particular, we are dazzled with its conversion of EBIT to free cash flow. Looking at all this data makes us feel a little cautious about Rashtriya Chemicals and Fertilizers's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. Be aware that Rashtriya Chemicals and Fertilizers is showing 3 warning signs in our investment analysis , 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.