These 4 Measures Indicate That Reds (ATH:KAMP) Is Using Debt Extensively

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. Importantly, Reds S.A. (ATH:KAMP) does carry debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

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What Is Reds's Debt?

The image below, which you can click on for greater detail, shows that at June 2020 Reds had debt of €35.1m, up from €32.1m in one year. And it doesn't have much cash, so its net debt is about the same.

A Look At Reds's Liabilities

According to the last reported balance sheet, Reds had liabilities of €13.9m due within 12 months, and liabilities of €29.9m due beyond 12 months. On the other hand, it had cash of €414.4k and €3.18m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €40.2m.

This deficit is considerable relative to its market capitalization of €63.2m, so it does suggest shareholders should keep an eye on Reds's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Reds shareholders face the double whammy of a high net debt to EBITDA ratio (8.7), and fairly weak interest coverage, since EBIT is just 1.6 times the interest expense. The debt burden here is substantial. The good news is that Reds grew its EBIT a smooth 88% over the last twelve months. Like a mother's loving embrace of a newborn that sort of growth builds resilience, putting the company in a stronger position to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Reds's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Reds's free cash flow amounted to 43% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Neither Reds's ability handle its debt, based on its EBITDA, nor its interest cover 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. Taking the abovementioned factors together we do think Reds'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. Be aware that Reds is showing 2 warning signs in our investment analysis , you should know about...

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.

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