Red Eléctrica Corporación (BME:REE) Seems To Use Debt Quite Sensibly

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Red Eléctrica Corporación, S.A. (BME:REE) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Red Eléctrica Corporación

What Is Red Eléctrica Corporación's Net Debt?

As you can see below, Red Eléctrica Corporación had €6.94b of debt, at June 2021, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has €1.18b in cash leading to net debt of about €5.76b.

A Look At Red Eléctrica Corporación's Liabilities

Zooming in on the latest balance sheet data, we can see that Red Eléctrica Corporación had liabilities of €2.14b due within 12 months and liabilities of €7.78b due beyond that. Offsetting these obligations, it had cash of €1.18b as well as receivables valued at €1.21b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €7.53b.

This deficit is considerable relative to its very significant market capitalization of €9.08b, so it does suggest shareholders should keep an eye on Red Eléctrica Corporación's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Red Eléctrica Corporación has net debt to EBITDA of 3.8 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 9.7 times its interest expense, and its net debt to EBITDA, was quite high, at 3.8. Notably Red Eléctrica Corporación's EBIT was pretty flat over the last year. We would prefer to see some earnings growth, because that always helps diminish debt. 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 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Red Eléctrica Corporación produced sturdy free cash flow equating to 69% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Both Red Eléctrica Corporación's ability to to convert EBIT to free cash flow and its interest cover gave us comfort that it can handle its debt. Having said that, its net debt to EBITDA somewhat sensitizes us to potential future risks to the balance sheet. It's also worth noting that Red Eléctrica Corporación is in the Electric Utilities industry, which is often considered to be quite defensive. 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. 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 Red Eléctrica Corporación has 2 warning signs (and 1 which shouldn't be ignored) we think you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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