Is Reliable Data Services (NSE:RELIABLE) Using Too Much Debt?

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

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Our analysis indicates that RELIABLE is potentially undervalued!

How Much Debt Does Reliable Data Services Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 Reliable Data Services had ₹163.9m of debt, an increase on ₹140.4m, over one year. However, because it has a cash reserve of ₹8.91m, its net debt is less, at about ₹155.0m.

How Healthy Is Reliable Data Services' Balance Sheet?

We can see from the most recent balance sheet that Reliable Data Services had liabilities of ₹293.0m falling due within a year, and liabilities of ₹109.0m due beyond that. Offsetting these obligations, it had cash of ₹8.91m as well as receivables valued at ₹386.2m due within 12 months. So its total liabilities are just about perfectly matched by its shorter-term, liquid assets.

This state of affairs indicates that Reliable Data Services' balance sheet looks quite solid, as its total liabilities are just about equal to its liquid assets. So while it's hard to imagine that the ₹502.6m company is struggling for cash, we still think it's worth monitoring its balance sheet.

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.

Reliable Data Services's net debt is sitting at a very reasonable 1.9 times its EBITDA, while its EBIT covered its interest expense just 3.4 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. We note that Reliable Data Services grew its EBIT by 29% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is Reliable Data Services'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Reliable Data Services saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Reliable Data Services's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we are dazzled with its EBIT growth rate. When we consider all the factors mentioned above, we do feel a bit cautious about Reliable Data Services's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Reliable Data Services 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.