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 can see that RWE Aktiengesellschaft (ETR:RWE) does use debt in its business. But is this debt a concern to shareholders?
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. 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 RWE's Debt?
As you can see below, at the end of September 2019, RWE had €7.62b of debt, up from €2.88b a year ago. Click the image for more detail. However, its balance sheet shows it holds €8.59b in cash, so it actually has €972.0m net cash.
A Look At RWE's Liabilities
We can see from the most recent balance sheet that RWE had liabilities of €18.9b falling due within a year, and liabilities of €23.6b due beyond that. Offsetting this, it had €8.59b in cash and €13.6b in receivables that were due within 12 months. So its liabilities total €20.2b more than the combination of its cash and short-term receivables.
When you consider that this deficiency exceeds the company's huge €15.3b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution. Given that RWE has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine RWE'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.
In the last year RWE had negative earnings before interest and tax, and actually shrunk its revenue by 3.1%, to €13b. We would much prefer see growth.
So How Risky Is RWE?
By their very nature companies that are losing money are more risky than those with a long history of profitability. And we do note that RWE had negative earnings before interest and tax (EBIT), over the last year. And over the same period it saw negative free cash outflow of €1.5b and booked a €1.0b accounting loss. But the saving grace is the €972.0m on the balance sheet. That means it could keep spending at its current rate for more than two years. Summing up, we're a little skeptical of this one, as it seems fairly risky in the absence of free cashflow. When we look at a riskier company, we like to check how their profits (or losses) are trending over time. Today, we're providing readers this interactive graph showing how RWE's profit, revenue, and operating cashflow have changed over the last few years.
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.
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