These 4 Measures Indicate That ROSSETI South (MCX:MRKY) Is Using Debt In A Risky Way

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Public Joint Stock Company "ROSSETI South" (MCX:MRKY) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.

View our latest analysis for ROSSETI South

What Is ROSSETI South's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2020 ROSSETI South had debt of ₽20.3b, up from ₽17.2b in one year. However, because it has a cash reserve of ₽1.06b, its net debt is less, at about ₽19.2b.

A Look At ROSSETI South's Liabilities

The latest balance sheet data shows that ROSSETI South had liabilities of ₽18.8b due within a year, and liabilities of ₽21.2b falling due after that. Offsetting these obligations, it had cash of ₽1.06b as well as receivables valued at ₽7.18b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by ₽31.7b.

This deficit casts a shadow over the ₽7.07b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, ROSSETI South would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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).

While ROSSETI South's debt to EBITDA ratio (3.7) suggests that it uses some debt, its interest cover is very weak, at 1.8, suggesting high leverage. It seems clear that the cost of borrowing money is negatively impacting returns for shareholders, of late. One redeeming factor for ROSSETI South is that it turned last year's EBIT loss into a gain of ₽2.8b, over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine ROSSETI South's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it is important to check how much of its earnings before interest and tax (EBIT) converts to actual free cash flow. Over the last year, ROSSETI South 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

On the face of it, ROSSETI South's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. Having said that, its ability to grow its EBIT isn't such a worry. We should also note that Electric Utilities industry companies like ROSSETI South commonly do use debt without problems. Taking into account all the aforementioned factors, it looks like ROSSETI South has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. 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. Case in point: We've spotted 3 warning signs for ROSSETI South you should be aware of, and 1 of them doesn't sit too well with us.

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.

When trading ROSSETI South or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.