Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, REN - Redes Energéticas Nacionais, SGPS, S.A. (ELI:RENE) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is REN - Redes Energéticas Nacionais SGPS's Debt?
As you can see below, REN - Redes Energéticas Nacionais SGPS had €2.85b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, it does have €61.5m in cash offsetting this, leading to net debt of about €2.79b.
A Look At REN - Redes Energéticas Nacionais SGPS' Liabilities
According to the last reported balance sheet, REN - Redes Energéticas Nacionais SGPS had liabilities of €925.0m due within 12 months, and liabilities of €2.92b due beyond 12 months. On the other hand, it had cash of €61.5m and €239.8m worth of receivables due within a year. So it has liabilities totalling €3.54b more than its cash and near-term receivables, combined.
The deficiency here weighs heavily on the €1.60b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, REN - Redes Energéticas Nacionais SGPS would likely require a major re-capitalisation if it had to pay its creditors today.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
REN - Redes Energéticas Nacionais SGPS has a rather high debt to EBITDA ratio of 6.3 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.4 times, suggesting it can responsibly service its obligations. Investors should also be troubled by the fact that REN - Redes Energéticas Nacionais SGPS saw its EBIT drop by 10% over the last twelve months. If things keep going like that, handling the debt will about as easy as bundling an angry house cat into its travel box. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if REN - Redes Energéticas Nacionais SGPS can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
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. During the last three years, REN - Redes Energéticas Nacionais SGPS generated free cash flow amounting to a very robust 95% of its EBIT, more than we'd expect. That puts it in a very strong position to pay down debt.
To be frank both REN - Redes Energéticas Nacionais SGPS's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. It's also worth noting that REN - Redes Energéticas Nacionais SGPS is in the Integrated Utilities industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that REN - Redes Energéticas Nacionais SGPS's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Case in point: We've spotted 2 warning signs for REN - Redes Energéticas Nacionais SGPS you should be aware of.
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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