Is Rede Energia Participações (BVMF:REDE3) A Risky Investment?

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.' 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. We can see that Rede Energia Participações S.A. (BVMF:REDE3) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Rede Energia Participações

What Is Rede Energia Participações's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 Rede Energia Participações had R$11.2b of debt, an increase on R$10.0b, over one year. On the flip side, it has R$1.93b in cash leading to net debt of about R$9.26b.

How Healthy Is Rede Energia Participações' Balance Sheet?

The latest balance sheet data shows that Rede Energia Participações had liabilities of R$5.23b due within a year, and liabilities of R$14.5b falling due after that. Offsetting this, it had R$1.93b in cash and R$4.30b in receivables that were due within 12 months. So its liabilities total R$13.5b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's R$11.1b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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).

Rede Energia Participações's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 5.7 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. One way Rede Energia Participações could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 15%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Rede Energia Participações's free cash flow amounted to 45% of its EBIT, less 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. But on the bright side, its ability to to grow its EBIT isn't too shabby at all. It's also worth noting that Rede Energia Participações is in the Electric Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Rede Energia Participações's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. For example, we've discovered 2 warning signs for Rede Energia Participações that you should be aware of before investing here.

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.