We Think Ramada Investimentos e Industria (ELI:RAM) Can Stay On Top Of Its Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Ramada Investimentos e Industria, S.A. (ELI:RAM) does use debt in its business. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Ramada Investimentos e Industria

What Is Ramada Investimentos e Industria's Net Debt?

You can click the graphic below for the historical numbers, but it shows that Ramada Investimentos e Industria had €57.8m of debt in September 2020, down from €81.9m, one year before. However, it also had €43.1m in cash, and so its net debt is €14.7m.

How Strong Is Ramada Investimentos e Industria's Balance Sheet?

We can see from the most recent balance sheet that Ramada Investimentos e Industria had liabilities of €47.5m falling due within a year, and liabilities of €41.0m due beyond that. On the other hand, it had cash of €43.1m and €35.2m worth of receivables due within a year. So its liabilities total €10.2m more than the combination of its cash and short-term receivables.

Given Ramada Investimentos e Industria has a market capitalization of €123.1m, it's hard to believe these liabilities pose much threat. However, we do think it is worth keeping an eye on its balance sheet strength, as it may change over time.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Ramada Investimentos e Industria has a low net debt to EBITDA ratio of only 1.2. And its EBIT easily covers its interest expense, being 12.1 times the size. So we're pretty relaxed about its super-conservative use of debt. On the other hand, Ramada Investimentos e Industria's EBIT dived 13%, over the last year. If that rate of decline in earnings continues, the company could find itself in a tight spot. 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 Ramada Investimentos e Industria 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Ramada Investimentos e Industria generated free cash flow amounting to a very robust 91% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.

Our View

The good news is that Ramada Investimentos e Industria's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But the stark truth is that we are concerned by its EBIT growth rate. When we consider the range of factors above, it looks like Ramada Investimentos e Industria is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 3 warning signs we've spotted with Ramada Investimentos e Industria .

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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