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. 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. We can see that Repsol, S.A. (BME:REP) does use debt in its business. But is this debt a concern to shareholders?
When Is Debt A Problem?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.
What Is Repsol's Net Debt?
The image below, which you can click on for greater detail, shows that Repsol had debt of €13.6b at the end of June 2019, a reduction from €15.0b over a year. On the flip side, it has €6.16b in cash leading to net debt of about €7.45b.
A Look At Repsol's Liabilities
According to the last reported balance sheet, Repsol had liabilities of €14.9b due within 12 months, and liabilities of €17.1b due beyond 12 months. Offsetting this, it had €6.16b in cash and €6.51b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €19.4b.
This deficit is considerable relative to its very significant market capitalization of €20.9b, so it does suggest shareholders should keep an eye on Repsol's use of debt. This suggests shareholders would heavily diluted if the company needed to shore up its balance sheet in a hurry.
We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Repsol's net debt of 1.5 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 9.2 times interest expense) certainly does not do anything to dispel this impression. The modesty of its debt load may become crucial for Repsol if management cannot prevent a repeat of the 20% cut to EBIT over the last year. Falling earnings (if the trend continues) could eventually make even modest debt quite risky. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Repsol'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.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Repsol produced sturdy free cash flow equating to 80% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.
Repsol's struggle to grow its EBIT had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. In particular, its conversion of EBIT to free cash flow was re-invigorating. When we consider all the factors discussed, it seems to us that Repsol is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. In light of our reservations about the company's balance sheet, it seems sensible to check if insiders have been selling shares recently.
If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.
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