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.' 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 note that Red Eléctrica Corporación, S.A. (BME:REE) does have debt on its balance sheet. But is this debt a concern to shareholders?
What Risk Does Debt Bring?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Red Eléctrica Corporación's Net Debt?
As you can see below, Red Eléctrica Corporación had €6.90b of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of €901.9m, its net debt is less, at about €6.00b.
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 €1.72b due within 12 months and liabilities of €7.78b due beyond that. Offsetting this, it had €901.9m in cash and €1.33b in receivables that were due within 12 months. 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 €9.06b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
With net debt to EBITDA of 3.9 Red Eléctrica Corporación has a fairly noticeable amount of debt. But the high interest coverage of 9.9 suggests it can easily service that debt. Notably Red Eléctrica Corporación's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Red Eléctrica Corporación's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Red Eléctrica Corporación produced sturdy free cash flow equating to 74% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.
Red Eléctrica Corporación's conversion of EBIT to free cash flow was a real positive on this analysis, as was its interest cover. On the other hand, its net debt to EBITDA makes us a little less comfortable about its debt. 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 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. 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 concerning) , and understanding them should be part of your investment process.
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.