Raia Drogasil (BVMF:RADL3) Seems To Use Debt Quite Sensibly

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.' 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. Importantly, Raia Drogasil S.A. (BVMF:RADL3) does carry debt. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Raia Drogasil

What Is Raia Drogasil's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2023 Raia Drogasil had debt of R$3.13b, up from R$2.32b in one year. However, it also had R$412.3m in cash, and so its net debt is R$2.72b.

How Strong Is Raia Drogasil's Balance Sheet?

The latest balance sheet data shows that Raia Drogasil had liabilities of R$8.08b due within a year, and liabilities of R$5.99b falling due after that. Offsetting these obligations, it had cash of R$412.3m as well as receivables valued at R$3.48b due within 12 months. So it has liabilities totalling R$10.2b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Raia Drogasil is worth R$44.7b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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 0.99 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.0 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. If Raia Drogasil can keep growing EBIT at last year's rate of 13% over the last year, then it will find its debt load easier to manage. There's no doubt that we learn most about debt from the balance sheet. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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 32% 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 interest cover was a real negative on this analysis, although the other factors we considered were considerably better. In particular, we thought its net debt to EBITDA was a positive. When we consider all the factors mentioned above, we do feel a bit cautious about Raia Drogasil's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. To that end, you should be aware of the 1 warning sign we've spotted with Raia Drogasil .

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.