Does Rede Energia Participações (BVMF:REDE3) Have A Healthy Balance Sheet?

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.' 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 Rede Energia Participações S.A. (BVMF:REDE3) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. If things get really bad, the lenders can take control of the business. 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.

See our latest analysis for Rede Energia Participações

What Is Rede Energia Participações's Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2024 Rede Energia Participações had R$14.7b of debt, an increase on R$12.2b, over one year. However, it also had R$2.78b in cash, and so its net debt is R$11.9b.

How Strong Is Rede Energia Participações' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Rede Energia Participações had liabilities of R$7.37b due within 12 months and liabilities of R$16.3b due beyond that. Offsetting this, it had R$2.78b in cash and R$4.79b in receivables that were due within 12 months. So its liabilities total R$16.1b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's R$13.9b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Rede Energia Participações's net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 5.3 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Rede Energia Participações grew its EBIT by 8.4% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Rede Energia Participações's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

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, Rede Energia Participações recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Rede Energia Participações's struggle to handle its total liabilities had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. For example, its EBIT growth rate is relatively strong. We should also note that Electric Utilities industry companies like Rede Energia Participações commonly do use debt without problems. When we consider all the factors discussed, it seems to us that Rede Energia Participações is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 2 warning signs for Rede Energia Participações that you should be aware of.

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.