Here's Why Rede Energia Participações (BVMF:REDE3) Has A Meaningful Debt Burden

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. 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. We note that Rede Energia Participações S.A. (BVMF:REDE3) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. If things get really bad, the lenders can take control of the business. 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.

See our latest analysis for Rede Energia Participações

What Is Rede Energia Participações's Net Debt?

As you can see below, at the end of March 2020, Rede Energia Participações had R$9.40b of debt, up from R$6.63b a year ago. Click the image for more detail. However, it does have R$1.81b in cash offsetting this, leading to net debt of about R$7.59b.

How Strong Is Rede Energia Participações's Balance Sheet?

According to the last reported balance sheet, Rede Energia Participações had liabilities of R$4.33b due within 12 months, and liabilities of R$10.8b due beyond 12 months. Offsetting these obligations, it had cash of R$1.81b as well as receivables valued at R$3.16b due within 12 months. So it has liabilities totalling R$10.2b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Rede Energia Participações is worth R$21.7b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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).

Rede Energia Participações's debt is 3.5 times its EBITDA, and its EBIT cover its interest expense 3.8 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. On a slightly more positive note, Rede Energia Participações grew its EBIT at 19% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Rede Energia Participações's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, Rede Energia Participações actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

Rede Energia Participações's conversion of EBIT to free cash flow was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its EBIT growth rate was re-invigorating. We should also note that Electric Utilities industry companies like Rede Energia Participações commonly do use debt without problems. Looking at all the angles mentioned above, it does seem to us that Rede Energia Participações 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. 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. Case in point: We've spotted 3 warning signs for Rede Energia Participações you should be aware of, and 1 of them makes us a bit uncomfortable.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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