Is Red 5 (ASX:RED) Using Too Much Debt?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Red 5 Limited (ASX:RED) does use debt in its business. But the more important question is: how much risk is that debt creating?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Red 5

What Is Red 5's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Red 5 had AU$172.3m of debt, an increase on none, over one year. On the flip side, it has AU$32.5m in cash leading to net debt of about AU$139.7m.

How Healthy Is Red 5's Balance Sheet?

According to the last reported balance sheet, Red 5 had liabilities of AU$111.7m due within 12 months, and liabilities of AU$282.9m due beyond 12 months. Offsetting this, it had AU$32.5m in cash and AU$10.5m in receivables that were due within 12 months. So it has liabilities totalling AU$351.5m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of AU$507.9m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Red 5'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.

In the last year Red 5 had a loss before interest and tax, and actually shrunk its revenue by 4.8%, to AU$165m. That's not what we would hope to see.

Caveat Emptor

Importantly, Red 5 had an earnings before interest and tax (EBIT) loss over the last year. Indeed, it lost AU$48m at the EBIT level. Considering that alongside the liabilities mentioned above does not give us much confidence that company should be using so much debt. So we think its balance sheet is a little strained, though not beyond repair. Another cause for caution is that is bled AU$101m in negative free cash flow over the last twelve months. So in short it's a really risky stock. 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. To that end, you should be aware of the 1 warning sign we've spotted with Red 5 .

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.

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.