Is Solaria Energía y Medio Ambiente (BME:SLR) Using Too Much Debt?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a 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. As with many other companies Solaria Energía y Medio Ambiente, S.A. (BME:SLR) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Our analysis indicates that SLR is potentially undervalued!

How Much Debt Does Solaria Energía y Medio Ambiente Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Solaria Energía y Medio Ambiente had €646.8m of debt, an increase on €494.2m, over one year. However, it also had €118.7m in cash, and so its net debt is €528.1m.

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

According to the last reported balance sheet, Solaria Energía y Medio Ambiente had liabilities of €191.7m due within 12 months, and liabilities of €680.2m due beyond 12 months. On the other hand, it had cash of €118.7m and €51.9m worth of receivables due within a year. So it has liabilities totalling €701.4m more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Solaria Energía y Medio Ambiente has a market capitalization of €1.81b, 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.

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.

Solaria Energía y Medio Ambiente has a debt to EBITDA ratio of 4.6 and its EBIT covered its interest expense 5.1 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. It is well worth noting that Solaria Energía y Medio Ambiente's EBIT shot up like bamboo after rain, gaining 85% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Solaria Energía y Medio Ambiente's ability to maintain a healthy balance sheet going forward. 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. Over the last three years, Solaria Energía y Medio Ambiente saw substantial negative free cash flow, in total. 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

Solaria Energía y Medio Ambiente's conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. Looking at all the angles mentioned above, it does seem to us that Solaria Energía y Medio Ambiente is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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, we've discovered 3 warning signs for Solaria Energía y Medio Ambiente that you should be aware of before investing here.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.