Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital. When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Réalités (EPA:ALREA) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Réalités's Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 Réalités had €78.4m of debt, an increase on €54.5m, over one year. On the flip side, it has €44.2m in cash leading to net debt of about €34.2m.
A Look At Réalités's Liabilities
Zooming in on the latest balance sheet data, we can see that Réalités had liabilities of €151.7m due within 12 months and liabilities of €43.5m due beyond that. Offsetting this, it had €44.2m in cash and €95.7m in receivables that were due within 12 months. So it has liabilities totalling €55.3m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of €52.6m, we think shareholders really should watch Réalités's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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.
Réalités has a debt to EBITDA ratio of 3.0, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 29.0 times its interest expense, implying the company isn't really paying full freight on that debt. Even if not sustainable, that is a good sign. Notably, Réalités's EBIT launched higher than Elon Musk, gaining a whopping 105% on last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Réalités's ability to maintain a healthy balance sheet going forward. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Réalités saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.
We feel some trepidation about Réalités's difficulty conversion of EBIT to free cash flow, but we've got positives to focus on, too. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. Taking the abovementioned factors together we do think Réalités's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Réalités's dividend history, without delay!
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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