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Rexel (EPA:RXL) Takes On Some Risk With Its Use Of Debt

Simply Wall St

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Rexel S.A. (EPA:RXL) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

See our latest analysis for Rexel

What Is Rexel's Debt?

The chart below, which you can click on for greater detail, shows that Rexel had €2.59b in debt in December 2018; about the same as the year before. However, because it has a cash reserve of €544.9m, its net debt is less, at about €2.04b.

ENXTPA:RXL Historical Debt, July 30th 2019

A Look At Rexel's Liabilities

The latest balance sheet data shows that Rexel had liabilities of €3.48b due within a year, and liabilities of €2.49b falling due after that. Offsetting these obligations, it had cash of €544.9m as well as receivables valued at €2.58b due within 12 months. So its liabilities total €2.84b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of €3.32b. This suggests shareholders would 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). 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).

With net debt to EBITDA of 3.2 Rexel has a fairly reasonable amount of debt. On the plus side, its EBIT was 7.9 times its interest expense, and its net debt to EBITDA, was quite high, at 3.2. Rexel grew its EBIT by 5.9% in the last year. Whilst that hardly knocks our socks off it is a positive when it comes to debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Rexel'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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Rexel's free cash flow amounted to 36% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While Rexel's net debt to EBITDA makes us cautious about it, its track record of staying on top of its total liabilities is no better. At least its interest cover gives us reason to be optimistic. Taking the abovementioned factors together we do think Rexel'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 Rexel's dividend history, without delay!

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.

We aim to bring you long-term focused research analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material.

If you spot an error that warrants correction, please contact the editor at editorial-team@simplywallst.com. 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. Simply Wall St has no position in the stocks mentioned. Thank you for reading.