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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.’ So it seems the smart money knows that debt – which is usually involved in bankruptcies – is a very important factor, when you assess how risky a company is. We can see that REA Group Limited (ASX:REA) does use debt in its business. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
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. 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. 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. When we think about a company’s use of debt, we first look at cash and debt together.
What Is REA Group’s Net Debt?
As you can see below, REA Group had AU$310.1m of debt at December 2018, down from AU$359.3m a year prior. However, it also had AU$59.8m in cash, and so its net debt is AU$250.3m.
A Look At REA Group’s Liabilities
According to the last reported balance sheet, REA Group had liabilities of AU$389.5m due within 12 months, and liabilities of AU$240.7m due beyond 12 months. On the other hand, it had cash of AU$59.8m and AU$150.0m worth of receivables due within a year. So its liabilities total AU$420.4m more than the combination of its cash and short-term receivables.
Of course, REA Group has a market capitalization of AU$13.0b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. Either way, since REA Group does have more debt than cash, it’s worth keeping an eye on its balance sheet.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
REA Group has a low net debt to EBITDA ratio of only 0.52. And its EBIT covers its interest expense a whopping 48.5 times over. So we’re pretty relaxed about its super-conservative use of debt. Also positive, REA Group grew its EBIT by 22% in the last year, and that should make it easier to pay down debt, going forward. There’s no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine REA Group’s ability to maintain a healthy balance sheet going forward. 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. So it’s worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, REA Group recorded free cash flow worth 63% 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.
REA Group’s interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14’s goalkeeper. And the good news does not stop there, as its EBIT growth rate 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. While debt does bring risk, when used wisely it can also bring a higher return on equity. We’d be very excited to see if REA Group insiders have been snapping up shares. If you are too, then click on this link right now to take a (free) peek at our list of reported insider transactions.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.