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Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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 Réalités (EPA:ALREA) makes use of debt. 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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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 Réalités
What Is Réalités's Debt?
You can click the graphic below for the historical numbers, but it shows that as of December 2018 Réalités had €78.4m of debt, an increase on €54.5m, over one year. On the flip side, it has €44.2m in cash leading to net debt of about €34.2m.
A Look At Réalités's Liabilities
Zooming in on the latest balance sheet data, we can see that Réalités had liabilities of €151.7m due within 12 months and liabilities of €43.5m due beyond that. Offsetting this, it had €44.2m in cash and €95.7m in receivables that were due within 12 months. So it has liabilities totalling €55.3m more than its cash and near-term receivables, combined.
Given this deficit is actually higher than the company's market capitalization of €52.6m, we think shareholders really should watch Réalités's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.