Solaria Energía y Medio Ambiente (BME:SLR) Takes On Some Risk With Its Use Of Debt

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. Importantly, Solaria Energía y Medio Ambiente, S.A. (BME:SLR) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for Solaria Energía y Medio Ambiente

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

As you can see below, at the end of December 2020, Solaria Energía y Medio Ambiente had €378.4m of debt, up from €327.0m a year ago. Click the image for more detail. However, it does have €81.6m in cash offsetting this, leading to net debt of about €296.8m.

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 €86.4m due within a year, and liabilities of €406.5m falling due after that. Offsetting this, it had €81.6m in cash and €24.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €387.4m.

This deficit isn't so bad because Solaria Energía y Medio Ambiente is worth €1.87b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

With a net debt to EBITDA ratio of 6.2, it's fair to say Solaria Energía y Medio Ambiente does have a significant amount of debt. However, its interest coverage of 2.7 is reasonably strong, which is a good sign. The silver lining is that Solaria Energía y Medio Ambiente grew its EBIT by 131% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. 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 it's worth checking how much of that EBIT is backed by 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

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 the good news is it seems to be able to grow its EBIT with ease. When we consider all the factors discussed, it seems to us that Solaria Energía y Medio Ambiente is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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. For example, we've discovered 3 warning signs for Solaria Energía y Medio Ambiente (2 are potentially serious!) 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. 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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