Red 5 (ASX:RED) Has A Pretty Healthy Balance Sheet
Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We note that Red 5 Limited (ASX:RED) does have debt on its balance sheet. 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. 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. When we think about a company's use of debt, we first look at cash and debt together.
View our latest analysis for Red 5
What Is Red 5's Debt?
You can click the graphic below for the historical numbers, but it shows that Red 5 had AU$4.96m of debt in December 2020, down from AU$19.7m, one year before. However, its balance sheet shows it holds AU$92.8m in cash, so it actually has AU$87.9m net cash.
How Healthy Is Red 5's Balance Sheet?
The latest balance sheet data shows that Red 5 had liabilities of AU$73.2m due within a year, and liabilities of AU$48.2m falling due after that. Offsetting these obligations, it had cash of AU$92.8m as well as receivables valued at AU$6.64m due within 12 months. So its liabilities total AU$21.9m more than the combination of its cash and short-term receivables.
Of course, Red 5 has a market capitalization of AU$335.1m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Red 5 also has more cash than debt, so we're pretty confident it can manage its debt safely.
Importantly, Red 5's EBIT fell a jaw-dropping 49% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. 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 Red 5 can strengthen its balance sheet over time. 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. While Red 5 has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last two years, Red 5 actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Summing up
We could understand if investors are concerned about Red 5's liabilities, but we can be reassured by the fact it has has net cash of AU$87.9m. And it impressed us with free cash flow of -AU$11m, being 228% of its EBIT. So we don't have any problem with Red 5's use of 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 instance, we've identified 3 warning signs for Red 5 (2 can't be ignored) you should be aware of.
At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.
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. 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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