Is Rent-A-Center (NASDAQ:RCII) Using Too Much 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.' 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, Rent-A-Center, Inc. (NASDAQ:RCII) does carry debt. But should shareholders be worried about its use of debt?

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 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Rent-A-Center

How Much Debt Does Rent-A-Center Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2021 Rent-A-Center had US$1.28b of debt, an increase on US$190.6m, over one year. However, it also had US$158.8m in cash, and so its net debt is US$1.12b.

How Healthy Is Rent-A-Center's Balance Sheet?

According to the last reported balance sheet, Rent-A-Center had liabilities of US$548.7m due within 12 months, and liabilities of US$1.65b due beyond 12 months. Offsetting this, it had US$158.8m in cash and US$131.9m in receivables that were due within 12 months. So its liabilities total US$1.91b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of US$2.86b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Rent-A-Center has net debt worth 2.2 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.7 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. It is well worth noting that Rent-A-Center's EBIT shot up like bamboo after rain, gaining 39% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Rent-A-Center 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. Over the last three years, Rent-A-Center recorded free cash flow worth a fulsome 92% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Happily, Rent-A-Center's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. When we consider the range of factors above, it looks like Rent-A-Center is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Rent-A-Center is showing 6 warning signs in our investment analysis , 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. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.