Here's Why Red Eléctrica Corporación (BME:RED) Can Manage Its Debt Responsibly

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 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. We can see that Red Eléctrica Corporación, S.A. (BME:RED) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Our analysis indicates that RED is potentially undervalued!

What Is Red Eléctrica Corporación's Net Debt?

As you can see below, Red Eléctrica Corporación had €6.34b of debt at June 2022, down from €6.96b a year prior. However, it does have €1.94b in cash offsetting this, leading to net debt of about €4.40b.

How Healthy Is Red Eléctrica Corporación's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Red Eléctrica Corporación had liabilities of €2.51b due within 12 months and liabilities of €7.34b due beyond that. Offsetting this, it had €1.94b in cash and €1.28b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €6.63b.

This is a mountain of leverage relative to its market capitalization of €8.19b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Red Eléctrica Corporación has net debt to EBITDA of 3.0 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 9.4 times its interest expense, and its net debt to EBITDA, was quite high, at 3.0. Sadly, Red Eléctrica Corporación's EBIT actually dropped 6.5% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Red Eléctrica Corporación can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Red Eléctrica Corporación recorded free cash flow worth a fulsome 88% of its EBIT, which is stronger than we'd usually expect. That positions it well to pay down debt if desirable to do so.

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 instance it seems like it has to struggle a bit to handle its total liabilities. We would also note that Electric Utilities industry companies like Red Eléctrica Corporación commonly do use debt without problems. Looking at all this data makes us feel a little cautious about Red Eléctrica Corporación'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. We've identified 2 warning signs with Red Eléctrica Corporación (at least 1 which is significant) , and understanding them should be part of your investment process.

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.