We Think RF Industries (NASDAQ:RFIL) Is Taking Some Risk With Its Debt

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 RF Industries, Ltd. (NASDAQ:RFIL) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for RF Industries

How Much Debt Does RF Industries Carry?

As you can see below, at the end of January 2023, RF Industries had US$15.0m of debt, up from none a year ago. Click the image for more detail. However, because it has a cash reserve of US$3.77m, its net debt is less, at about US$11.2m.

A Look At RF Industries' Liabilities

Zooming in on the latest balance sheet data, we can see that RF Industries had liabilities of US$16.7m due within 12 months and liabilities of US$27.4m due beyond that. Offsetting these obligations, it had cash of US$3.77m as well as receivables valued at US$13.9m due within 12 months. So its liabilities total US$26.5m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since RF Industries has a market capitalization of US$47.4m, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

RF Industries's net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 6.7 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Importantly, RF Industries's EBIT fell a jaw-dropping 42% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 RF Industries can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. During the last two years, RF Industries burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both RF Industries's conversion of EBIT to free cash flow and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. Overall, it seems to us that RF Industries's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with RF Industries , and understanding them should be part of your investment process.

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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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.