Is Raia Drogasil (BVMF:RADL3) A Risky Investment?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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 Raia Drogasil S.A. (BVMF:RADL3) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Raia Drogasil

What Is Raia Drogasil's Net Debt?

As you can see below, at the end of September 2020, Raia Drogasil had R$1.73b of debt, up from R$1.24b a year ago. Click the image for more detail. However, because it has a cash reserve of R$600.2m, its net debt is less, at about R$1.13b.

A Look At Raia Drogasil's Liabilities

We can see from the most recent balance sheet that Raia Drogasil had liabilities of R$4.19b falling due within a year, and liabilities of R$4.63b due beyond that. Offsetting this, it had R$600.2m in cash and R$1.76b in receivables that were due within 12 months. So it has liabilities totalling R$6.46b more than its cash and near-term receivables, combined.

Since publicly traded Raia Drogasil shares are worth a total of R$41.2b, 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.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Looking at its net debt to EBITDA of 0.83 and interest cover of 2.6 times, it seems to us that Raia Drogasil is probably using debt in a pretty reasonable way. 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 11% 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 ultimately the future profitability of the business will decide if Raia Drogasil 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Raia Drogasil recorded free cash flow of 36% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Based on what we've seen Raia Drogasil is not finding it easy, given its interest cover, but the other factors we considered give us cause to be optimistic. In particular, we thought its net debt to EBITDA was a positive. 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. For example, we've discovered 2 warning signs for Raia Drogasil (1 doesn't sit too well with us!) that you should be aware of before investing here.

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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