Here's Why RGC Resources (NASDAQ:RGCO) Is Weighed Down By Its Debt Load

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, RGC Resources, Inc. (NASDAQ:RGCO) does carry debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for RGC Resources

What Is RGC Resources's Debt?

The image below, which you can click on for greater detail, shows that at December 2020 RGC Resources had debt of US$135.1m, up from US$114.3m in one year. And it doesn't have much cash, so its net debt is about the same.

A Look At RGC Resources' Liabilities

The latest balance sheet data shows that RGC Resources had liabilities of US$22.5m due within a year, and liabilities of US$179.3m falling due after that. Offsetting this, it had US$736.7k in cash and US$9.85m in receivables that were due within 12 months. So its liabilities total US$191.2m more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's US$183.8m market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 6.2, it's fair to say RGC Resources does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 3.3 times, suggesting it can responsibly service its obligations. Given the debt load, it's hardly ideal that RGC Resources's EBIT was pretty flat over the last twelve months. 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 RGC Resources'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, RGC Resources saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, RGC Resources's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least its EBIT growth rate is not so bad. We should also note that Gas Utilities industry companies like RGC Resources commonly do use debt without problems. Overall, it seems to us that RGC Resources's balance sheet is really quite a risk to the business. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. To that end, you should be aware of the 1 warning sign we've spotted with RGC Resources .

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.

If you’re looking to trade RGC Resources, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

This article by Simply Wall St is general in nature. 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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.