These 4 Measures Indicate That Reliable Data Services (NSE:RELIABLE) Is Using Debt Extensively

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 Reliable Data Services Limited (NSE:RELIABLE) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Reliable Data Services

What Is Reliable Data Services's Debt?

As you can see below, at the end of September 2020, Reliable Data Services had ₹132.9m of debt, up from ₹106.2m a year ago. Click the image for more detail. However, it does have ₹11.1m in cash offsetting this, leading to net debt of about ₹121.7m.

How Strong Is Reliable Data Services' Balance Sheet?

According to the last reported balance sheet, Reliable Data Services had liabilities of ₹252.2m due within 12 months, and liabilities of ₹124.5m due beyond 12 months. Offsetting this, it had ₹11.1m in cash and ₹272.6m in receivables that were due within 12 months. So its liabilities total ₹93.0m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Reliable Data Services has a market capitalization of ₹258.0m, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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).

Reliable Data Services's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 4.1 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. We saw Reliable Data Services grow its EBIT by 9.5% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But you can't view debt in total isolation; since Reliable Data Services 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into 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 cast it in a significantly better light. For example, its EBIT growth rate is relatively strong. When we consider all the factors discussed, it seems to us that Reliable Data Services is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with Reliable Data Services (at least 2 which can't be ignored) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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