We Think RGC Resources (NASDAQ:RGCO) 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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that RGC Resources, Inc. (NASDAQ:RGCO) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for RGC Resources

What Is RGC Resources's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2021 RGC Resources had US$133.5m of debt, an increase on US$126.0m, over one year. And it doesn't have much cash, so its net debt is about the same.

How Healthy Is RGC Resources' Balance Sheet?

We can see from the most recent balance sheet that RGC Resources had liabilities of US$26.0m falling due within a year, and liabilities of US$184.4m due beyond that. Offsetting this, it had US$1.27m in cash and US$4.79m in receivables that were due within 12 months. So its liabilities total US$204.3m more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's US$182.6m 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.

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).

RGC Resources has a rather high debt to EBITDA ratio of 5.6 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.6 times, suggesting it can responsibly service its obligations. On a slightly more positive note, RGC Resources grew its EBIT at 17% over the last year, further increasing its ability to manage debt. 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 RGC Resources 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, RGC Resources burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both RGC Resources's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But at least it's pretty decent at growing its EBIT; that's encouraging. 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for RGC Resources (1 is significant) you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.