The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. 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. Importantly, Royal Mail plc (LON:RMG) does carry debt. But the real question is whether this debt is making the company risky.
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. Ultimately, if the company can’t fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Royal Mail
What Is Royal Mail’s Debt?
The image below, which you can click on for greater detail, shows that Royal Mail had debt of UK£443.0m at the end of September 2019, a reduction from UK£562.0m over a year. However, it does have UK£222.0m in cash offsetting this, leading to net debt of about UK£221.0m.
How Strong Is Royal Mail’s Balance Sheet?
According to the last reported balance sheet, Royal Mail had liabilities of UK£2.03b due within 12 months, and liabilities of UK£1.78b due beyond 12 months. On the other hand, it had cash of UK£222.0m and UK£1.29b worth of receivables due within a year. So it has liabilities totalling UK£2.30b more than its cash and near-term receivables, combined.
When you consider that this deficiency exceeds the company’s UK£1.65b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Royal Mail has a low net debt to EBITDA ratio of only 0.26. And its EBIT covers its interest expense a whopping 23.3 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Royal Mail grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. 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, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Royal Mail recorded free cash flow worth a fulsome 82% of its EBIT, which is stronger than we’d usually expect. That puts it in a very strong position to pay down debt.
Royal Mail’s interest cover was a real positive on this analysis, as was its conversion of EBIT to free cash flow. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. Considering this range of data points, we think Royal Mail is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. Be aware that Royal Mail is showing 4 warning signs in our investment analysis , and 1 of those can’t be ignored…
If, after all that, you’re more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned.
We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Thank you for reading.
Discounted cash flow calculation for every stock
Simply Wall St does a detailed discounted cash flow calculation every 6 hours for every stock on the market, so if you want to find the intrinsic value of any company just search here. It’s FREE.