Legendary fund manager Li Lu (who Charlie Munger backed) once said, ‘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, REV Group, Inc. (NYSE:REVG) 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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

What Is REV Group’s Debt?

The image below, which you can click on for greater detail, shows that REV Group had debt of US$332.1m at the end of January 2021, a reduction from US$461.7m over a year. On the flip side, it has US$9.10m in cash leading to net debt of about US$323.0m.

A Look At REV Group’s Liabilities

We can see from the most recent balance sheet that REV Group had liabilities of US$403.1m falling due within a year, and liabilities of US$380.7m due beyond that. Offsetting this, it had US$9.10m in cash and US$207.7m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$567.0m.

This deficit isn’t so bad because REV Group is worth US$1.21b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it’s clear that we should definitely closely examine whether it can manage its debt without 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 0.86 times and a disturbingly high net debt to EBITDA ratio of 5.5 hit our confidence in REV Group like a one-two punch to the gut. This means we’d consider it to have a heavy debt load. Worse, REV Group’s EBIT was down 39% over the last year. If earnings keep going like that over the long term, it has a snowball’s chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if REV Group can strengthen its balance sheet over time.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, REV Group produced sturdy free cash flow equating to 70% of its EBIT, about what we’d expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

On the face of it, REV Group’s interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at converting EBIT to free cash flow; that’s encouraging. Once we consider all the factors above, together, it seems to us that REV Group’s debt is making it a bit risky. That’s not necessarily a bad thing, but we’d generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet – far from it.