Is Redeia Corporación (BME:RED) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Redeia Corporación, S.A. (BME:RED) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Redeia Corporación

How Much Debt Does Redeia Corporación Carry?

The image below, which you can click on for greater detail, shows that Redeia Corporación had debt of €6.07b at the end of June 2023, a reduction from €6.34b over a year. However, it does have €1.74b in cash offsetting this, leading to net debt of about €4.34b.

How Healthy Is Redeia Corporación's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Redeia Corporación had liabilities of €2.77b due within 12 months and liabilities of €7.14b due beyond that. Offsetting these obligations, it had cash of €1.74b as well as receivables valued at €1.47b due within 12 months. So its liabilities total €6.70b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of €7.97b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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

Redeia Corporación's net debt is 3.2 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 11.6 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. Unfortunately, Redeia Corporación saw its EBIT slide 7.8% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Redeia 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Redeia Corporación recorded free cash flow worth a fulsome 90% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Redeia Corporación's conversion of EBIT to free cash flow was a real positive on this analysis, as was its interest cover. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. It's also worth noting that Redeia Corporación is in the Electric Utilities industry, which is often considered to be quite defensive. When we consider all the factors mentioned above, we do feel a bit cautious about Redeia 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. 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. Case in point: We've spotted 3 warning signs for Redeia Corporación you should be aware of, and 2 of them are potentially serious.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.