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We Think Royal Mail (LON:RMG) 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 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. 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 A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, 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.

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View our latest analysis for Royal Mail

What Is Royal Mail's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2020 Royal Mail had UK£1.64b of debt, an increase on UK£431.0m, over one year. However, its balance sheet shows it holds UK£1.67b in cash, so it actually has UK£35.0m net cash.

debt-equity-history-analysis
debt-equity-history-analysis

A Look At Royal Mail's Liabilities

The latest balance sheet data shows that Royal Mail had liabilities of UK£3.10b due within a year, and liabilities of UK£2.30b falling due after that. On the other hand, it had cash of UK£1.67b and UK£1.20b worth of receivables due within a year. So it has liabilities totalling UK£2.5b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's UK£1.74b 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. Royal Mail boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

The modesty of its debt load may become crucial for Royal Mail if management cannot prevent a repeat of the 32% cut to EBIT over the last year. When it comes to paying off debt, falling earnings are no more useful than sugary sodas are for your health. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Royal Mail'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Royal Mail has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Royal Mail actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Summing up

Although Royal Mail's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£35.0m. And it impressed us with free cash flow of UK£608m, being 118% of its EBIT. Despite its cash we think that Royal Mail seems to struggle to grow its EBIT, so we are wary of the stock. 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. Consider for instance, the ever-present spectre of investment risk. We've identified 1 warning sign with Royal Mail , and understanding them should be part of your investment process.

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.

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.

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