RIZAP GROUP (SPSE:2928) 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.' 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 can see that RIZAP GROUP, Inc. (SPSE:2928) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for RIZAP GROUP

What Is RIZAP GROUP's Debt?

You can click the graphic below for the historical numbers, but it shows that RIZAP GROUP had JP¥45.6b of debt in September 2020, down from JP¥116.3b, one year before. However, because it has a cash reserve of JP¥34.8b, its net debt is less, at about JP¥10.8b.

A Look At RIZAP GROUP's Liabilities

We can see from the most recent balance sheet that RIZAP GROUP had liabilities of JP¥79.8b falling due within a year, and liabilities of JP¥62.3b due beyond that. Offsetting these obligations, it had cash of JP¥34.8b as well as receivables valued at JP¥21.7b due within 12 months. So its liabilities total JP¥85.6b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's JP¥77.9b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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).

RIZAP GROUP has a very low debt to EBITDA ratio of 0.76 so it is strange to see weak interest coverage, with last year's EBIT being only 0.80 times the interest expense. So while we're not necessarily alarmed we think that its debt is far from trivial. Importantly, RIZAP GROUP's EBIT fell a jaw-dropping 88% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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 RIZAP GROUP 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last two years, RIZAP GROUP actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On the face of it, RIZAP GROUP's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. Once we consider all the factors above, together, it seems to us that RIZAP GROUP's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. To that end, you should learn about the 3 warning signs we've spotted with RIZAP GROUP (including 2 which is are potentially serious) .

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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