Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett said “volatility is far from synonymous with risk.” When we think of a company’s risk, we always like to look at its use of debt, because over-indebtedness can lead to ruin. Like many other companies Reliance Infrastructure Limited (NSE:RELINFRA) uses debt. But the real question is whether this debt makes the business risky.
When is debt a problem?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. If things go really bad, lenders can take over the business. However, a more usual (but still expensive) situation is when a company has to dilute shareholders at a cheap share price just to keep debt under control. By replacing dilution, however, debt can be a great tool for companies that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business has is to look at its cash and debt together.
See our latest analysis for Reliance Infrastructure
What is Reliance Infrastructure’s net debt?
The image below, which you can click on for more details, shows that as of March 2022, Reliance Infrastructure had a debt of ₹127.2 billion, up from ₹87.8 billion in a year. On the other hand, he has ₹12.5 billion in cash, resulting in a net debt of around ₹114.7 billion.
How healthy is Reliance Infrastructure’s balance sheet?
According to the latest published balance sheet, Reliance Infrastructure had liabilities of ₹339.0 billion due within 12 months and liabilities of ₹123.0 billion due beyond 12 months. As compensation for these obligations, it had cash of ₹12.5 billion as well as receivables valued at ₹114.5 billion due within 12 months. It therefore has liabilities totaling ₹335.1 billion more than its cash and short-term receivables, combined.
This deficit casts a shadow over the ₹47.0 billion society like a colossus towering above mere mortals. We would therefore be watching his balance sheet closely, no doubt. Ultimately, Reliance Infrastructure would likely need a major recapitalization if its creditors were to demand repayment.
We use two main ratios to inform us about debt to earnings levels. The first is net debt divided by earnings before interest, taxes, depreciation and amortization (EBITDA), while the second is how often its earnings before interest and taxes (EBIT) covers its interest expense (or its interests, for short). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
While we are not concerned about Reliance Infrastructure’s net debt to EBITDA ratio of 3.3, we believe its extremely low interest coverage of 1.5x is a sign of high leverage. It seems clear that the cost of borrowing money is having a negative impact on shareholder returns lately. The good news is that Reliance Infrastructure has improved its EBIT by 3.5% over the last twelve months, gradually reducing its level of debt relative to its earnings. When analyzing debt levels, the balance sheet is the obvious starting point. But it is Reliance Infrastructure’s earnings that will influence the balance sheet going forward. So, when considering debt, it is definitely worth looking at the earnings trend. Click here for an interactive preview.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, Reliance Infrastructure has produced strong free cash flow equivalent to 65% of its EBIT, which is what we expected. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
To be frank, Reliance Infrastructure’s interest coverage and track record of keeping total liabilities under control makes us rather uncomfortable with its level of leverage. But at least it’s decent enough to convert EBIT to free cash flow; it’s encouraging. It should also be noted that Reliance Infrastructure belongs to the electric utility sector, which is often considered quite defensive. Looking at the big picture, it seems clear to us that Reliance Infrastructure’s use of debt creates risks for the business. If all goes well, this should boost returns, but on the other hand, the risk of permanent capital loss is increased by debt. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. For example – Reliance Infrastructure has 2 warning signs we think you should know.
If you are interested in investing in companies that can generate profits without the burden of debt, then check out this free list of growing companies that have net cash on the balance sheet.
Feedback on this article? Concerned about content? Get in touch with us directly. You can also email the editorial team (at) Simplywallst.com.
This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.
Calculation of discounted cash flows for each share
Simply Wall St performs a detailed calculation of discounted cash flow every 6 hours for every stock in the market, so if you want to find the intrinsic value of any company, just search here. It’s free.