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. Importantly, Ritchie Bros. Auctioneers Incorporated (NYSE:RBA) does carry debt. But the real question is whether this debt is making the company risky.
Why Does Debt Bring Risk?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Ritchie Bros. Auctioneers's Net Debt?
As you can see below, Ritchie Bros. Auctioneers had US$665.8m of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has US$278.8m in cash leading to net debt of about US$387.0m.
How Healthy Is Ritchie Bros. Auctioneers' Balance Sheet?
We can see from the most recent balance sheet that Ritchie Bros. Auctioneers had liabilities of US$514.6m falling due within a year, and liabilities of US$824.6m due beyond that. Offsetting this, it had US$278.8m in cash and US$136.3m in receivables that were due within 12 months. So its liabilities total US$924.0m more than the combination of its cash and short-term receivables.
Since publicly traded Ritchie Bros. Auctioneers shares are worth a total of US$6.30b, it seems unlikely that this level of liabilities would be a major threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With net debt sitting at just 1.2 times EBITDA, Ritchie Bros. Auctioneers is arguably pretty conservatively geared. And it boasts interest cover of 7.7 times, which is more than adequate. Another good sign is that Ritchie Bros. Auctioneers has been able to increase its EBIT by 24% in twelve months, making it easier to pay down debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Ritchie Bros. Auctioneers can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Ritchie Bros. Auctioneers generated free cash flow amounting to a very robust 89% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
The good news is that Ritchie Bros. Auctioneers's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think Ritchie Bros. Auctioneers's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Ritchie Bros. Auctioneers , and understanding them should be part of your investment process.
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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