Does Red Eléctrica Corporación (BME:RED) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. As with many other companies Red Eléctrica Corporación, S.A. (BME:RED) makes use of debt. But the more important question is: how much risk is that debt creating?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Red Eléctrica Corporación

What Is Red Eléctrica Corporación's Net Debt?

The chart below, which you can click on for greater detail, shows that Red Eléctrica Corporación had €6.24b in debt in December 2022; about the same as the year before. However, because it has a cash reserve of €1.55b, its net debt is less, at about €4.69b.

How Healthy Is Red Eléctrica Corporación's Balance Sheet?

We can see from the most recent balance sheet that Red Eléctrica Corporación had liabilities of €2.90b falling due within a year, and liabilities of €6.98b due beyond that. On the other hand, it had cash of €1.55b and €1.36b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €6.98b.

This deficit is considerable relative to its market capitalization of €8.96b, so it does suggest shareholders should keep an eye on Red Eléctrica Corporación's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With net debt to EBITDA of 3.4 Red Eléctrica Corporación has a fairly noticeable amount of debt. On the plus side, its EBIT was 8.7 times its interest expense, and its net debt to EBITDA, was quite high, at 3.4. Sadly, Red Eléctrica Corporación's EBIT actually dropped 5.9% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Red Eléctrica Corporación can strengthen its balance sheet over time. 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 we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Red Eléctrica Corporación actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

On our analysis Red Eléctrica Corporación's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its level of total liabilities makes us a little nervous about its debt. We would also note that Electric Utilities industry companies like Red Eléctrica Corporación commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Red Eléctrica Corporación's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. To that end, you should learn about the 2 warning signs we've spotted with Red Eléctrica Corporación (including 1 which is a bit concerning) .

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.