Drax Group (LON:DRX) Takes On Some Risk With Its Use Of 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.' 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. We note that Drax Group plc (LON:DRX) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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Why Does Debt Bring Risk?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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 Drax Group's Net Debt?

As you can see below, Drax Group had UK£1.18b of debt at December 2024, down from UK£1.43b a year prior. However, because it has a cash reserve of UK£356.0m, its net debt is less, at about UK£820.7m.

How Healthy Is Drax Group's Balance Sheet?

We can see from the most recent balance sheet that Drax Group had liabilities of UK£1.54b falling due within a year, and liabilities of UK£1.77b due beyond that. On the other hand, it had cash of UK£356.0m and UK£436.0m worth of receivables due within a year. So its liabilities total UK£2.51b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of UK£2.27b, we think shareholders really should watch Drax Group's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

Check out our latest analysis for Drax Group

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.

Drax Group has a low net debt to EBITDA ratio of only 0.73. And its EBIT covers its interest expense a whopping 10.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. But the other side of the story is that Drax Group saw its EBIT decline by 7.1% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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 Drax Group'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. Looking at the most recent three years, Drax Group recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We feel some trepidation about Drax Group's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its interest cover and net debt to EBITDA give us some confidence in its ability to manage its debt. Taking the abovementioned factors together we do think Drax Group's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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 Drax Group (1 can't be ignored!) that you should be aware of before investing here.

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.