These 4 Measures Indicate That Red Eléctrica Corporación (BME:REE) Is Using Debt Reasonably Well

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 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. As with many other companies Red Eléctrica Corporación, S.A. (BME:REE) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Red Eléctrica Corporación

What Is Red Eléctrica Corporación's Debt?

The chart below, which you can click on for greater detail, shows that Red Eléctrica Corporación had €6.90b in debt in September 2021; about the same as the year before. However, because it has a cash reserve of €901.9m, its net debt is less, at about €6.00b.

How Strong 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 €1.72b due within 12 months and liabilities of €7.78b due beyond that. On the other hand, it had cash of €901.9m and €1.33b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €7.27b.

This is a mountain of leverage even relative to its gargantuan market capitalization of €9.80b. 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 3.9 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 9.9 suggests it can easily service that debt. Importantly Red Eléctrica Corporación's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish debt. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Red Eléctrica Corporación recorded free cash flow worth 74% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

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. On the other hand, its net debt to EBITDA makes us a little less comfortable about its debt. It's also worth noting that Red Eléctrica Corporación is in the Electric Utilities industry, which is often considered to be quite defensive. When we consider all the elements mentioned above, it seems to us that Red Eléctrica Corporación is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Red Eléctrica Corporación (of which 1 can't be ignored!) you should know about.

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.

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.

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