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

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Raia Drogasil S.A. (BVMF:RADL3) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. 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.

See our latest analysis for Raia Drogasil

How Much Debt Does Raia Drogasil Carry?

As you can see below, at the end of June 2022, Raia Drogasil had R$2.37b of debt, up from R$1.56b a year ago. Click the image for more detail. On the flip side, it has R$818.8m in cash leading to net debt of about R$1.55b.

How Healthy Is Raia Drogasil's Balance Sheet?

We can see from the most recent balance sheet that Raia Drogasil had liabilities of R$5.70b falling due within a year, and liabilities of R$5.41b due beyond that. Offsetting these obligations, it had cash of R$818.8m as well as receivables valued at R$2.22b due within 12 months. So its liabilities total R$8.06b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Raia Drogasil has a market capitalization of R$36.6b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Raia Drogasil's low debt to EBITDA ratio of 0.74 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.8 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. One way Raia Drogasil could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 13%, as it did over the last year. 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'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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Raia Drogasil produced sturdy free cash flow equating to 52% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Raia Drogasil's net debt to EBITDA was a real positive on this analysis, as was its EBIT growth rate. Having said that, its interest cover somewhat sensitizes us to potential future risks to the balance sheet. Considering this range of data points, we think Raia Drogasil is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. Over time, share prices tend to follow earnings per share, so if you're interested in Raia Drogasil, you may well want to click here to check an interactive graph of its earnings per share history.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.