We Think Red 5 (ASX:RED) Can Stay On Top Of Its Debt
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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. As with many other companies Red 5 Limited (ASX:RED) makes use of debt. 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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.
See our latest analysis for Red 5
What Is Red 5's Net Debt?
The image below, which you can click on for greater detail, shows that Red 5 had debt of AU$11.9m at the end of June 2020, a reduction from AU$19.7m over a year. However, its balance sheet shows it holds AU$116.2m in cash, so it actually has AU$104.4m net cash.
How Healthy Is Red 5's Balance Sheet?
The latest balance sheet data shows that Red 5 had liabilities of AU$96.5m due within a year, and liabilities of AU$50.9m falling due after that. Offsetting this, it had AU$116.2m in cash and AU$7.08m in receivables that were due within 12 months. So its liabilities total AU$24.1m more than the combination of its cash and short-term receivables.
Of course, Red 5 has a market capitalization of AU$620.7m, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward. While it does have liabilities worth noting, Red 5 also has more cash than debt, so we're pretty confident it can manage its debt safely.
Notably, Red 5 made a loss at the EBIT level, last year, but improved that to positive EBIT of AU$5.8m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Red 5 can strengthen its balance sheet over time. 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. While Red 5 has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Happily for any shareholders, Red 5 actually produced more free cash flow than EBIT over the last year. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.
Summing up
We could understand if investors are concerned about Red 5's liabilities, but we can be reassured by the fact it has has net cash of AU$104.4m. The cherry on top was that in converted 252% of that EBIT to free cash flow, bringing in AU$15m. So we are not troubled with Red 5's debt use. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Red 5 (1 is concerning) you should be aware of.
Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.
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. We aim to bring you long-term focused analysis driven by fundamental data. Note that our analysis may not factor in the latest price-sensitive company announcements or qualitative material. Simply Wall St has no position in any stocks mentioned.
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