Does Raia Drogasil (BVMF:RADL3) Have A Healthy Balance Sheet?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Raia Drogasil S.A. (BVMF:RADL3) does carry debt. But the real question is whether this debt is making the company risky.

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. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Raia Drogasil

What Is Raia Drogasil's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Raia Drogasil had debt of R$3.10b, up from R$2.27b in one year. However, because it has a cash reserve of R$619.5m, its net debt is less, at about R$2.48b.

How Healthy Is Raia Drogasil's Balance Sheet?

We can see from the most recent balance sheet that Raia Drogasil had liabilities of R$7.70b falling due within a year, and liabilities of R$5.89b due beyond that. Offsetting these obligations, it had cash of R$619.5m as well as receivables valued at R$3.32b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$9.65b.

Since publicly traded Raia Drogasil shares are worth a total of R$48.4b, it seems unlikely that this level of liabilities would be a major threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Raia Drogasil's low debt to EBITDA ratio of 0.95 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 2.9 times last year does give us pause. So we'd recommend keeping a close eye on the impact financing costs are having on the business. If Raia Drogasil can keep growing EBIT at last year's rate of 19% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Raia Drogasil'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Raia Drogasil recorded free cash flow of 41% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Raia Drogasil's EBIT growth rate was a real positive on this analysis, as was its net debt to EBITDA. On the other hand, its interest cover makes us a little less comfortable about its debt. When we consider all the elements mentioned above, it seems to us that Raia Drogasil is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Raia Drogasil you should know about.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.