Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Regal Rexnord Corporation (NYSE:RRX) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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 Regal Rexnord's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Regal Rexnord had US$5.70b of debt in June 2024, down from US$6.68b, one year before. On the flip side, it has US$510.4m in cash leading to net debt of about US$5.19b.

How Strong Is Regal Rexnord's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Regal Rexnord had liabilities of US$1.23b due within 12 months and liabilities of US$7.01b due beyond that. Offsetting these obligations, it had cash of US$510.4m as well as receivables valued at US$892.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$6.84b.

This deficit is considerable relative to its very significant market capitalization of US$11.2b, so it does suggest shareholders should keep an eye on Regal Rexnord's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While Regal Rexnord's debt to EBITDA ratio (4.2) suggests that it uses some debt, its interest cover is very weak, at 1.8, suggesting high leverage. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Fortunately, Regal Rexnord grew its EBIT by 6.4% in the last year, slowly shrinking its debt relative to earnings. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Regal Rexnord'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 business needs free cash flow to pay off debt; accounting profits just don't cut it. 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, Regal Rexnord produced sturdy free cash flow equating to 68% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Regal Rexnord's struggle to cover its interest expense with its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example its conversion of EBIT to free cash flow was refreshing. Looking at all the angles mentioned above, it does seem to us that Regal Rexnord is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Regal Rexnord is showing 1 warning sign in our investment analysis , you should know about...

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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.