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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. 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 Realco S.A. (EBR:REAL) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.
View our latest analysis for Realco
How Much Debt Does Realco Carry?
As you can see below, Realco had €3.01m of debt, at December 2018, which is about the same the year before. You can click the chart for greater detail. However, because it has a cash reserve of €724.6k, its net debt is less, at about €2.29m.
How Healthy Is Realco's Balance Sheet?
According to the last reported balance sheet, Realco had liabilities of €2.44m due within 12 months, and liabilities of €2.42m due beyond 12 months. On the other hand, it had cash of €724.6k and €1.96m worth of receivables due within a year. So its liabilities total €2.18m more than the combination of its cash and short-term receivables.
Of course, Realco has a market capitalization of €11.7m, so these liabilities are probably manageable. Having said that, it's clear that we should continue to monitor its balance sheet, lest it change for the worse.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
Realco has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 3.0 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On the other hand, Realco grew its EBIT by 30% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. There's no doubt that we learn most about debt from the balance sheet. But it is Realco's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.