We Think Red 5 (ASX:RED) Can Stay On Top Of Its Debt

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. Importantly, Red 5 Limited (ASX:RED) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Red 5

How Much Debt Does Red 5 Carry?

The image below, which you can click on for greater detail, shows that Red 5 had debt of AU$4.96m at the end of December 2020, a reduction from AU$19.7m over a year. However, it does have AU$92.8m in cash offsetting this, leading to net cash of AU$87.9m.

How Healthy Is Red 5's Balance Sheet?

We can see from the most recent balance sheet that Red 5 had liabilities of AU$73.2m falling due within a year, and liabilities of AU$48.2m due beyond that. On the other hand, it had cash of AU$92.8m and AU$6.64m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$21.9m.

Of course, Red 5 has a market capitalization of AU$335.1m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse. While it does have liabilities worth noting, Red 5 also has more cash than debt, so we're pretty confident it can manage its debt safely.

Shareholders should be aware that Red 5's EBIT was down 49% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Red 5 can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While Red 5 has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Red 5 actually produced more free cash flow than EBIT over the last two years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Summing up

While it is always sensible to look at a company's total liabilities, it is very reassuring that Red 5 has AU$87.9m in net cash. The cherry on top was that in converted 228% of that EBIT to free cash flow, bringing in -AU$11m. So we are not troubled with Red 5's debt use. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Red 5 (including 2 which don't sit too well with us) .

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.

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This article by Simply Wall St is general in nature. 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.
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