Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies REN - Redes Energéticas Nacionais, SGPS, S.A. (ELI:RENE) makes use of 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is REN - Redes Energéticas Nacionais SGPS's Net Debt?
The image below, which you can click on for greater detail, shows that at September 2019 REN - Redes Energéticas Nacionais SGPS had debt of €2.82b, up from €2.69b in one year. However, it also had €171.5m in cash, and so its net debt is €2.65b.
How Healthy Is REN - Redes Energéticas Nacionais SGPS's Balance Sheet?
The latest balance sheet data shows that REN - Redes Energéticas Nacionais SGPS had liabilities of €1.03b due within a year, and liabilities of €2.82b falling due after that. On the other hand, it had cash of €171.5m and €267.3m worth of receivables due within a year. So its liabilities total €3.41b more than the combination of its cash and short-term receivables.
The deficiency here weighs heavily on the €1.80b 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. At the end of the day, REN - Redes Energéticas Nacionais SGPS would probably need a major re-capitalization if its creditors were to demand repayment.
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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
REN - Redes Energéticas Nacionais SGPS has a rather high debt to EBITDA ratio of 5.8 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 4.3 times, suggesting it can responsibly service its obligations. More concerning, REN - Redes Energéticas Nacionais SGPS saw its EBIT drop by 7.6% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. The balance sheet is clearly the area to focus on when you are analysing debt. 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, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, REN - Redes Energéticas Nacionais SGPS actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.
On the face of it, REN - Redes Energéticas Nacionais SGPS's net debt to EBITDA left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We should also note that Integrated Utilities industry companies like REN - Redes Energéticas Nacionais SGPS commonly do use debt without problems. 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 all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. Given REN - Redes Energéticas Nacionais SGPS has a strong balance sheet is profitable and pays a dividend, it would be good to know how fast its dividends are growing, if at all. You can find out instantly by clicking this link.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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