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.’ 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 Reliance Steel & Aluminum Co. (NYSE:RS) does use debt in its business. But the more important question is: how much risk is that debt creating?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Reliance Steel & Aluminum’s Net Debt?
The chart below, which you can click on for greater detail, shows that Reliance Steel & Aluminum had US$1.65b in debt in September 2021; about the same as the year before. However, it does have US$638.4m in cash offsetting this, leading to net debt of about US$1.01b.
How Healthy Is Reliance Steel & Aluminum’s Balance Sheet?
The latest balance sheet data shows that Reliance Steel & Aluminum had liabilities of US$1.01b due within a year, and liabilities of US$2.38b falling due after that. On the other hand, it had cash of US$638.4m and US$1.69b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$1.05b.
Given Reliance Steel & Aluminum has a humongous market capitalization of US$10.1b, it’s hard to believe these liabilities pose much threat. Having said that, it’s clear that we should continue to monitor its balance sheet, lest it change for the worse.
We measure a company’s debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Reliance Steel & Aluminum’s net debt is only 0.57 times its EBITDA. And its EBIT covers its interest expense a whopping 24.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Reliance Steel & Aluminum grew its EBIT by 103% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. 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 Reliance Steel & Aluminum can strengthen its balance sheet over time.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Reliance Steel & Aluminum recorded free cash flow worth a fulsome 81% of its EBIT, which is stronger than we’d usually expect. That positions it well to pay down debt if desirable to do so.
Reliance Steel & Aluminum’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And that’s just the beginning of the good news since its conversion of EBIT to free cash flow is also very heartening. It looks Reliance Steel & Aluminum has no trouble standing on its own two feet, and it has no reason to fear its lenders.