Stock Analysis

We Think Raia Drogasil (BVMF:RADL3) Can Stay On Top Of Its Debt

BOVESPA:RADL3
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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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, Raia Drogasil S.A. (BVMF:RADL3) does carry debt. But should shareholders be worried about its use of debt?

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. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Raia Drogasil

What Is Raia Drogasil's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Raia Drogasil had R$1.73b of debt, an increase on R$1.24b, over one year. However, it also had R$600.2m in cash, and so its net debt is R$1.13b.

debt-equity-history-analysis
BOVESPA:RADL3 Debt to Equity History March 10th 2021

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 these obligations, it had cash of R$600.2m as well as receivables valued at R$1.76b due within 12 months. So it has liabilities totalling R$6.46b more than its cash and near-term receivables, combined.

Of course, Raia Drogasil has a market capitalization of R$36.7b, so these liabilities are probably manageable. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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. 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 11% 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Raia Drogasil's free cash flow amounted to 36% of its EBIT, less 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. Looking at all this data makes us feel a little cautious about Raia Drogasil's debt levels. 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Raia Drogasil has 2 warning signs (and 1 which is concerning) we think you should know about.

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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This article by Simply Wall St is general in nature. 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.
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