REN - Redes Energéticas Nacionais SGPS (ELI:RENE) Takes On Some Risk With Its Use Of Debt

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 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. We note that REN - Redes Energéticas Nacionais, SGPS, S.A. (ELI:RENE) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for REN - Redes Energéticas Nacionais SGPS

How Much Debt Does REN - Redes Energéticas Nacionais SGPS Carry?

As you can see below, REN - Redes Energéticas Nacionais SGPS had €2.88b of debt, at June 2021, which is about the same as the year before. You can click the chart for greater detail. However, it also had €308.9m in cash, and so its net debt is €2.57b.

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

We can see from the most recent balance sheet that REN - Redes Energéticas Nacionais SGPS had liabilities of €859.7m falling due within a year, and liabilities of €3.20b due beyond that. Offsetting this, it had €308.9m in cash and €268.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €3.48b.

The deficiency here weighs heavily on the €1.69b 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 5.9, it's fair to say REN - Redes Energéticas Nacionais SGPS does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 4.8 times, suggesting it can responsibly service its obligations. Unfortunately, REN - Redes Energéticas Nacionais SGPS saw its EBIT slide 9.6% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine REN - Redes Energéticas Nacionais SGPS's ability to maintain a healthy balance sheet going forward. 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 it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, REN - Redes Energéticas Nacionais SGPS actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

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. We should also note that Integrated Utilities industry companies like REN - Redes Energéticas Nacionais SGPS commonly do use debt without problems. Overall, we think it's fair to say that REN - Redes Energéticas Nacionais SGPS has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For example - REN - Redes Energéticas Nacionais SGPS has 2 warning signs we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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.

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