Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Royal Mail plc (LON:RMG) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Royal Mail Carry?
You can click the graphic below for the historical numbers, but it shows that Royal Mail had UK£431.0m of debt in March 2019, down from UK£606.0m, one year before. However, it does have UK£236.0m in cash offsetting this, leading to net debt of about UK£195.0m.
A Look At Royal Mail's Liabilities
We can see from the most recent balance sheet that Royal Mail had liabilities of UK£1.99b falling due within a year, and liabilities of UK£793.0m due beyond that. Offsetting these obligations, it had cash of UK£236.0m as well as receivables valued at UK£1.21b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£1.33b.
This deficit is considerable relative to its market capitalization of UK£1.93b, so it does suggest shareholders should keep an eye on Royal Mail's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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.
Royal Mail's net debt is only 0.24 times its EBITDA. And its EBIT covers its interest expense a whopping 49.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, Royal Mail grew its EBIT by 73% over the last twelve months, and that growth will make it easier to handle 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 Royal Mail 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Royal Mail produced sturdy free cash flow equating to 71% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
The good news is that Royal Mail's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But, on a more sombre note, we are a little concerned by its level of total liabilities. When we consider the range of factors above, it looks like Royal Mail 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. We'd be motivated to research the stock further if we found out that Royal Mail insiders have bought shares recently. If you would too, then you're in luck, since today we're sharing our list of reported insider transactions for free.
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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