These 4 Measures Indicate That Rede Energia Participações (BVMF:REDE3) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Rede Energia Participações S.A. (BVMF:REDE3) makes use of debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View 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 September 2020 Rede Energia Participações had R$9.21b of debt, an increase on R$8.17b, over one year. However, it does have R$2.86b in cash offsetting this, leading to net debt of about R$6.34b.

A Look At Rede Energia Participações' Liabilities

According to the last reported balance sheet, Rede Energia Participações had liabilities of R$4.80b due within 12 months, and liabilities of R$10.7b due beyond 12 months. On the other hand, it had cash of R$2.86b and R$3.08b worth of receivables due within a year. So its liabilities total R$9.55b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Rede Energia Participações is worth R$23.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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 has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 4.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Rede Energia Participações grew its EBIT by 6.8% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Rede Energia Participações will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. Looking at the most recent three years, Rede Energia Participações recorded free cash flow of 31% 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 conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But it seems to be able to grow its EBIT without much trouble. We should also note that Electric Utilities industry companies like Rede Energia Participações commonly do use debt without problems. Looking at all the angles mentioned above, it does seem to us that Rede Energia Participações is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for Rede Energia Participações that you should be aware of before investing here.

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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