RIZAP GROUP (SPSE:2928) Takes On Some Risk With Its Use Of 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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that RIZAP GROUP, Inc. (SPSE:2928) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for RIZAP GROUP

What Is RIZAP GROUP's Debt?

The image below, which you can click on for greater detail, shows that RIZAP GROUP had debt of JP¥36.8b at the end of December 2020, a reduction from JP¥105.5b over a year. On the flip side, it has JP¥33.4b in cash leading to net debt of about JP¥3.38b.

How Healthy Is RIZAP GROUP's Balance Sheet?

According to the last reported balance sheet, RIZAP GROUP had liabilities of JP¥75.6b due within 12 months, and liabilities of JP¥58.1b due beyond 12 months. Offsetting these obligations, it had cash of JP¥33.4b as well as receivables valued at JP¥23.5b due within 12 months. So it has liabilities totalling JP¥76.8b more than its cash and near-term receivables, combined.

This deficit isn't so bad because RIZAP GROUP is worth JP¥131.3b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

RIZAP GROUP has a very low debt to EBITDA ratio of 0.21 so it is strange to see weak interest coverage, with last year's EBIT being only 2.4 times the interest expense. So one way or the other, it's clear the debt levels are not trivial. Shareholders should be aware that RIZAP GROUP's EBIT was down 63% last year. 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 it is RIZAP GROUP'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. Over the last two years, RIZAP GROUP actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

While RIZAP GROUP's EBIT growth rate has us nervous. To wit both its conversion of EBIT to free cash flow and net debt to EBITDA were encouraging signs. We think that RIZAP GROUP'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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for RIZAP GROUP (of which 2 are concerning!) you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. 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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