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

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 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. 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?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Raia Drogasil

How Much Debt Does Raia Drogasil Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2022 Raia Drogasil had R$2.27b of debt, an increase on R$1.56b, over one year. However, it does have R$371.2m in cash offsetting this, leading to net debt of about R$1.89b.

How Healthy Is Raia Drogasil's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Raia Drogasil had liabilities of R$6.04b due within 12 months and liabilities of R$5.37b due beyond that. On the other hand, it had cash of R$371.2m and R$2.64b worth of receivables due within a year. So it has liabilities totalling R$8.41b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Raia Drogasil is worth R$37.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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.

While Raia Drogasil's low debt to EBITDA ratio of 0.84 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.4 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Also relevant is that Raia Drogasil has grown its EBIT by a very respectable 20% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Raia Drogasil 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Raia Drogasil recorded free cash flow of 49% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Raia Drogasil's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its interest cover does undermine this impression a bit. All these things considered, it appears that Raia Drogasil can comfortably handle its current debt levels. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.