We Think Red Eléctrica Corporación (BME:REE) Is Taking Some Risk With Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Red Eléctrica Corporación, S.A. (BME:REE) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Red Eléctrica Corporación

How Much Debt Does Red Eléctrica Corporación Carry?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Red Eléctrica Corporación had €6.89b of debt, an increase on €5.62b, over one year. However, because it has a cash reserve of €422.4m, its net debt is less, at about €6.47b.

A Look At Red Eléctrica Corporación's Liabilities

The latest balance sheet data shows that Red Eléctrica Corporación had liabilities of €1.31b due within a year, and liabilities of €7.99b falling due after that. On the other hand, it had cash of €422.4m and €1.43b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €7.44b.

This is a mountain of leverage even relative to its gargantuan market capitalization of €8.78b. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Red Eléctrica Corporación has net debt to EBITDA of 4.2 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 7.6 times its interest expense, and its net debt to EBITDA, was quite high, at 4.2. Unfortunately, Red Eléctrica Corporación saw its EBIT slide 5.7% 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 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Red Eléctrica Corporación recorded free cash flow worth 57% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

While Red Eléctrica Corporación's level of total liabilities makes us cautious about it, its track record of managing its debt, based on its EBITDA, is no better. At least its interest cover gives us reason to be optimistic. It's also worth noting that Red Eléctrica Corporación is in the Electric Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Red Eléctrica Corporación's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For instance, we've identified 2 warning signs for Red Eléctrica Corporación that you should be aware of.

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.

When trading Red Eléctrica Corporación or any other investment, use the platform considered by many to be the Professional's Gateway to the Worlds Market, Interactive Brokers. You get the lowest-cost* trading on stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

This article by Simply Wall St is general in nature. 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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.