REA Group (ASX:REA) Has A Pretty Healthy Balance Sheet

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. We can see that REA Group Limited (ASX:REA) does use debt in its business. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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.

Check out our latest analysis for REA Group

What Is REA Group's Debt?

The chart below, which you can click on for greater detail, shows that REA Group had AU$239.5m in debt in December 2020; about the same as the year before. However, it also had AU$179.9m in cash, and so its net debt is AU$59.7m.

How Strong Is REA Group's Balance Sheet?

According to the last reported balance sheet, REA Group had liabilities of AU$415.1m due within 12 months, and liabilities of AU$245.1m due beyond 12 months. On the other hand, it had cash of AU$179.9m and AU$155.3m worth of receivables due within a year. So its liabilities total AU$325.1m more than the combination of its cash and short-term receivables.

Having regard to REA Group's size, it seems that its liquid assets are well balanced with its total liabilities. So while it's hard to imagine that the AU$22.2b company is struggling for cash, we still think it's worth monitoring its balance sheet. But either way, REA Group has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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's net debt is only 0.14 times its EBITDA. And its EBIT covers its interest expense a whopping 112 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. While REA Group doesn't seem to have gained much on the EBIT line, at least earnings remain stable for now. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual 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

Happily, REA Group's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its net debt to EBITDA is also very heartening. Zooming out, REA Group seems to use debt quite reasonably; and that gets the nod from us. After all, sensible leverage can boost returns on equity. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for REA Group you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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