Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that ‘Volatility is far from synonymous with risk.’ 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 can see that Red Eléctrica Corporación, S.A. (BME:REE) does use debt in its business. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
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. 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. The first step when considering a company’s debt levels is to consider its cash and debt together.
What Is Red Eléctrica Corporación’s Net Debt?
As you can see below, Red Eléctrica Corporación had €6.69b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of €517.6m, its net debt is less, at about €6.17b.
A Look At Red Eléctrica Corporación’s Liabilities
Zooming in on the latest balance sheet data, we can see that Red Eléctrica Corporación had liabilities of €1.46b due within 12 months and liabilities of €7.89b due beyond that. Offsetting these obligations, it had cash of €517.6m as well as receivables valued at €1.34b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €7.49b.
This deficit is considerable relative to its market capitalization of €8.07b, so it does suggest shareholders should keep an eye on Red Eléctrica Corporación’s use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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.
With net debt to EBITDA of 4.1 Red Eléctrica Corporación has a fairly noticeable amount of debt. On the plus side, its EBIT was 8.3 times its interest expense, and its net debt to EBITDA, was quite high, at 4.1. Sadly, Red Eléctrica Corporación’s EBIT actually dropped 5.8% in the last year. 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 Red Eléctrica Corporación’s ability to maintain a healthy balance sheet going forward.
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 most recent three years, Red Eléctrica Corporación recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Even if we have reservations about how easily Red Eléctrica Corporación is capable of managing its debt, based on its EBITDA,, its conversion of EBIT to free cash flow and interest cover make us think feel relatively unconcerned. It’s also worth noting that Red Eléctrica Corporación is in the Electric Utilities industry, which is often considered to be quite defensive. We think that Red Eléctrica Corporación’s debt does make it a bit risky, after considering the aforementioned data points together. That’s not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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.