Is REA Group (ASX:REA) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. Importantly, REA Group Limited (ASX:REA) does carry debt. But should shareholders be worried about its use of debt?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.

Check out our latest analysis for REA Group

What Is REA Group's Net Debt?

As you can see below, at the end of June 2021, REA Group had AU$413.4m of debt, up from AU$239.2m a year ago. Click the image for more detail. However, it also had AU$168.9m in cash, and so its net debt is AU$244.5m.

How Strong Is REA Group's Balance Sheet?

We can see from the most recent balance sheet that REA Group had liabilities of AU$351.6m falling due within a year, and liabilities of AU$881.5m due beyond that. On the other hand, it had cash of AU$168.9m and AU$275.6m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$788.6m.

Given REA Group has a humongous market capitalization of AU$22.3b, it's hard to believe these liabilities pose much threat. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Carrying virtually no net debt, REA Group has a very light debt load indeed.

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).

REA Group has a low net debt to EBITDA ratio of only 0.52. And its EBIT easily covers its interest expense, being 104 times the size. So we're pretty relaxed about its super-conservative use of debt. Also good is that REA Group grew its EBIT at 15% 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 ultimately the future profitability of the business will decide if REA Group can strengthen its balance sheet over time. 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 company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, REA Group recorded free cash flow worth 68% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that REA Group's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its net debt to EBITDA also supports that impression! Looking at the bigger picture, we think REA Group's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. Over time, share prices tend to follow earnings per share, so if you're interested in REA Group, you may well want to click here to check an interactive graph of its earnings per share history.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.