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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Rent-A-Center, Inc. (NASDAQ:RCII) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Rent-A-Center's Net Debt?
The image below, which you can click on for greater detail, shows that at June 2021 Rent-A-Center had debt of US$1.28b, up from US$190.7m in one year. On the flip side, it has US$145.1m in cash leading to net debt of about US$1.13b.
How Healthy Is Rent-A-Center's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Rent-A-Center had liabilities of US$597.7m due within 12 months and liabilities of US$1.61b due beyond that. Offsetting these obligations, it had cash of US$145.1m as well as receivables valued at US$120.8m due within 12 months. So its liabilities total US$1.94b more than the combination of its cash and short-term receivables.
This deficit isn't so bad because Rent-A-Center is worth US$4.23b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
With a debt to EBITDA ratio of 2.4, Rent-A-Center uses debt artfully but responsibly. And the alluring interest cover (EBIT of 9.6 times interest expense) certainly does not do anything to dispel this impression. Notably, Rent-A-Center's EBIT launched higher than Elon Musk, gaining a whopping 176% on last year. 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 Rent-A-Center'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, 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 96% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
Happily, Rent-A-Center's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. Zooming out, Rent-A-Center seems to use debt quite reasonably; and that gets the nod from us. 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. For example Rent-A-Center has 5 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.
When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.
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