Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies Royal Mail plc (LON:RMG) makes use of debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Royal Mail's Net Debt?
As you can see below, Royal Mail had UK£872.0m of debt, at March 2022, which is about the same as the year before. You can click the chart for greater detail. However, it does have UK£1.21b in cash offsetting this, leading to net cash of UK£335.0m.
How Strong Is Royal Mail's Balance Sheet?
According to the last reported balance sheet, Royal Mail had liabilities of UK£2.74b due within 12 months, and liabilities of UK£2.61b due beyond 12 months. Offsetting this, it had UK£1.21b in cash and UK£1.59b in receivables that were due within 12 months. So its liabilities total UK£2.54b more than the combination of its cash and short-term receivables.
This is a mountain of leverage relative to its market capitalization of UK£2.65b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. Despite its noteworthy liabilities, Royal Mail boasts net cash, so it's fair to say it does not have a heavy debt load!
But the bad news is that Royal Mail has seen its EBIT plunge 11% in the last twelve months. We think hat kind of performance, if repeated frequently, could well lead to difficulties for the stock. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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. Over the last three years, Royal Mail recorded free cash flow worth a fulsome 94% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.
While Royal Mail does have more liabilities than liquid assets, it also has net cash of UK£335.0m. The cherry on top was that in converted 94% of that EBIT to free cash flow, bringing in UK£557m. So we don't have any problem with Royal Mail's use of debt. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Royal Mail (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.
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.
Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.
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.
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