Warren Buffett said: “Volatility is far from synonymous with risk. It’s natural to consider a company’s balance sheet when looking at its riskiness, as debt is often involved when a company fails. We note that REA Group Limited (ASX:REA) has debt on its balance sheet. But the real question is whether this debt makes the business risky.
What risk does debt carry?
Debt is a tool to help businesses grow, but if a business is unable to repay its lenders, it exists at their mercy. An integral part of capitalism is the process of “creative destruction” where bankrupt companies are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity at a low price, thereby permanently diluting shareholders. Of course, debt can be an important tool in businesses, especially capital-intensive businesses. When we think about a company’s use of debt, we first look at cash and debt together.
Check out our latest analysis for the REA Group
What is the debt of the REA group?
The image below, which you can click on for more details, shows that in December 2021, the REA Group had a debt of 411.7 million Australian dollars, compared to 239.5 million Australian dollars in one year . On the other hand, he has A$194.8 million in cash, resulting in a net debt of around A$216.9 million.
How healthy is the balance sheet of the REA group?
Zooming in on the latest balance sheet data, we can see that the REA Group had liabilities of A$289.9 million due within 12 months and liabilities of A$860.7 million due beyond. As compensation for these obligations, it had cash of A$194.8 million and receivables valued at A$310.9 million due within 12 months. Thus, its liabilities total A$644.9 million more than the combination of its cash and short-term receivables.
Given that publicly traded REA Group shares are worth a very impressive total of A$18.0 billion, it seems unlikely that this level of liabilities will pose a major threat. That said, it is clear that we must continue to monitor its record, lest it deteriorate. Having virtually no net debt, the REA group has very little debt.
We measure a company’s leverage against its earning power by looking at its net debt divided by its earnings before interest, taxes, depreciation and amortization (EBITDA) and calculating how easily its earnings before interest and taxes (EBIT ) covers its interest charge (interest coverage). In this way, we consider both the absolute amount of debt, as well as the interest rates paid on it.
REA Group has a low net debt to EBITDA ratio of just 0.40. And its EBIT easily covers its interest charges, which is 87.9 times the size. So we’re pretty relaxed about his super-conservative use of debt. Also positive, the REA Group has increased its EBIT by 29% over the last year, which should facilitate the repayment of debt in the future. The balance sheet is clearly the area to focus on when analyzing debt. But ultimately, the company’s future profitability will decide whether REA Group can strengthen its balance sheet over time. So if you are focused on the future, you can check out this free report showing analyst earnings forecast.
Finally, a business needs free cash flow to pay off its debts; book profits are not enough. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the past three years, the REA Group has recorded free cash flow of 68% of its EBIT, which is about normal, given that free cash flow excludes interest and taxes. This free cash flow puts the company in a good position to repay its debt, should it arise.
Our point of view
REA Group’s interest coverage suggests he can manage his debt as easily as Cristiano Ronaldo could score a goal against an Under-14 keeper. And this is only the beginning of good news since its EBIT growth rate is also very encouraging. Overall, we do not believe that REA Group is taking bad risks, as its debt seems modest to us. So we are not worried about using a little leverage on the balance sheet. When analyzing debt levels, the balance sheet is the obvious starting point. But at the end of the day, every business can contain risks that exist outside of the balance sheet. We have identified 1 warning sign with REA Group, and understanding them should be part of your investment process.
In the end, sometimes it’s easier to focus on companies that don’t even need to take on debt. Readers can access a list of growth stocks with no net debt 100% freeat present.
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This Simply Wall St article is general in nature. We provide commentary based on historical data and analyst forecasts only using unbiased methodology and our articles are not intended to be financial advice. It is not a recommendation to buy or sell stocks and does not take into account your objectives or financial situation. Our goal is to bring you targeted long-term analysis based on fundamental data. Note that our analysis may not take into account the latest announcements from price-sensitive companies or qualitative materials. Simply Wall St has no position in the stocks mentioned.