Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Ritchie Bros. Auctioneers Incorporated (NYSE:RBA) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. 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, 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 step when considering a company's debt levels is to consider its cash and debt together.
What Is Ritchie Bros. Auctioneers's Debt?
As you can see below, Ritchie Bros. Auctioneers had US$652.8m of debt at September 2020, down from US$695.1m a year prior. However, it does have US$470.3m in cash offsetting this, leading to net debt of about US$182.6m.
A Look At Ritchie Bros. Auctioneers's Liabilities
The latest balance sheet data shows that Ritchie Bros. Auctioneers had liabilities of US$753.5m due within a year, and liabilities of US$819.6m falling due after that. Offsetting this, it had US$470.3m in cash and US$334.1m in receivables that were due within 12 months. So its liabilities total US$768.7m more than the combination of its cash and short-term receivables.
Given Ritchie Bros. Auctioneers has a market capitalization of US$7.75b, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.
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).
With net debt sitting at just 0.59 times EBITDA, Ritchie Bros. Auctioneers is arguably pretty conservatively geared. And this view is supported by the solid interest coverage, with EBIT coming in at 7.1 times the interest expense over the last year. Another good sign is that Ritchie Bros. Auctioneers has been able to increase its EBIT by 26% in twelve months, making it easier to pay down debt. 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 Ritchie Bros. Auctioneers's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Ritchie Bros. Auctioneers actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.
Happily, Ritchie Bros. Auctioneers's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Considering this range of factors, it seems to us that Ritchie Bros. Auctioneers is quite prudent with its debt, and the risks seem well managed. So we're not worried about the use of a little leverage on the balance sheet. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Ritchie Bros. Auctioneers is showing 2 warning signs in our investment analysis , you should know about...
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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