Does REN - Redes Energéticas Nacionais SGPS (ELI:RENE) Have A Healthy Balance Sheet?

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.' 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 can see that REN - Redes Energéticas Nacionais, SGPS, S.A. (ELI:RENE) does use debt in its business. But should shareholders be worried about its use of debt?

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. If things get really bad, the lenders can take control of the business. 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. 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.

Our analysis indicates that RENE is potentially undervalued!

What Is REN - Redes Energéticas Nacionais SGPS's Net Debt?

The image below, which you can click on for greater detail, shows that REN - Redes Energéticas Nacionais SGPS had debt of €2.64b at the end of June 2022, a reduction from €2.88b over a year. On the flip side, it has €545.6m in cash leading to net debt of about €2.09b.

How Strong Is REN - Redes Energéticas Nacionais SGPS' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that REN - Redes Energéticas Nacionais SGPS had liabilities of €1.46b due within 12 months and liabilities of €2.76b due beyond that. Offsetting this, it had €545.6m in cash and €313.9m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €3.35b.

The deficiency here weighs heavily on the €1.65b 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 definitely think shareholders need to watch this one closely. After all, REN - Redes Energéticas Nacionais SGPS would likely require a major re-capitalisation if it had to pay its creditors today.

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.

REN - Redes Energéticas Nacionais SGPS's debt is 4.7 times its EBITDA, and its EBIT cover its interest expense 6.2 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. We saw REN - Redes Energéticas Nacionais SGPS grow its EBIT by 3.7% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, REN - Redes Energéticas Nacionais SGPS actually produced more free cash flow than EBIT. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

REN - Redes Energéticas Nacionais SGPS's level of total liabilities and net debt to EBITDA definitely weigh on it, in our esteem. But its conversion of EBIT to free cash flow tells a very different story, and suggests some resilience. We should also note that Integrated Utilities industry companies like REN - Redes Energéticas Nacionais SGPS commonly do use debt without problems. When we consider all the factors discussed, it seems to us that REN - Redes Energéticas Nacionais SGPS is taking some risks with its use of debt. 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. But ultimately, every company can contain risks that exist outside of the balance sheet. We've identified 2 warning signs with REN - Redes Energéticas Nacionais SGPS , and understanding them should be part of your investment process.

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. 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.