Here's Why Solaria Energía y Medio Ambiente (BME:SLR) Has A Meaningful Debt Burden

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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 Solaria Energía y Medio Ambiente, S.A. (BME:SLR) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Solaria Energía y Medio Ambiente

What Is Solaria Energía y Medio Ambiente's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2022 Solaria Energía y Medio Ambiente had debt of €873.9m, up from €595.1m in one year. On the flip side, it has €150.8m in cash leading to net debt of about €723.1m.

How Healthy Is Solaria Energía y Medio Ambiente's Balance Sheet?

The latest balance sheet data shows that Solaria Energía y Medio Ambiente had liabilities of €185.2m due within a year, and liabilities of €897.0m falling due after that. On the other hand, it had cash of €150.8m and €49.9m worth of receivables due within a year. So its liabilities total €881.5m more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Solaria Energía y Medio Ambiente has a market capitalization of €1.79b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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 a net debt to EBITDA ratio of 5.0, it's fair to say Solaria Energía y Medio Ambiente does have a significant amount of debt. However, its interest coverage of 5.3 is reasonably strong, which is a good sign. Importantly, Solaria Energía y Medio Ambiente grew its EBIT by 67% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Solaria Energía y Medio Ambiente 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Solaria Energía y Medio Ambiente burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Neither Solaria Energía y Medio Ambiente's ability to convert EBIT to free cash flow nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. Taking the abovementioned factors together we do think Solaria Energía y Medio Ambiente'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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with Solaria Energía y Medio Ambiente , and understanding them should be part of your investment process.

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.