Is Raia Drogasil (BVMF:RADL3) Using Too Much Debt?

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.' 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. Importantly, Raia Drogasil S.A. (BVMF:RADL3) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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

What Is Raia Drogasil's Debt?

The image below, which you can click on for greater detail, shows that at March 2023 Raia Drogasil had debt of R$2.28b, up from R$2.17b in one year. However, it does have R$372.3m in cash offsetting this, leading to net debt of about R$1.90b.

How Healthy Is Raia Drogasil's Balance Sheet?

We can see from the most recent balance sheet that Raia Drogasil had liabilities of R$7.62b falling due within a year, and liabilities of R$5.11b due beyond that. On the other hand, it had cash of R$372.3m and R$3.03b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$9.33b.

Since publicly traded Raia Drogasil shares are worth a total of R$47.3b, it seems unlikely that this level of liabilities would be a major threat. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

While Raia Drogasil's low debt to EBITDA ratio of 0.75 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.1 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. Importantly, Raia Drogasil grew its EBIT by 51% over the last twelve months, and that growth will make it easier to handle its 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by 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

The good news is that Raia Drogasil's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its interest cover. Looking at all the aforementioned factors together, it strikes us that Raia Drogasil can handle its debt fairly comfortably. 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. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of Raia Drogasil's earnings per share history for free.

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.