Advertisement

We Think reach4entertainment enterprises (LON:R4E) Is Taking Some Risk With 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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that reach4entertainment enterprises plc (LON:R4E) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

ADVERTISEMENT

See our latest analysis for reach4entertainment enterprises

What Is reach4entertainment enterprises's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2019 reach4entertainment enterprises had debt of UK£3.73m, up from UK£3.08m in one year. However, it does have UK£3.76m in cash offsetting this, leading to net cash of UK£31.0k.

AIM:R4E Historical Debt, February 20th 2020
AIM:R4E Historical Debt, February 20th 2020

How Healthy Is reach4entertainment enterprises's Balance Sheet?

We can see from the most recent balance sheet that reach4entertainment enterprises had liabilities of UK£28.1m falling due within a year, and liabilities of UK£11.6m due beyond that. On the other hand, it had cash of UK£3.76m and UK£22.6m worth of receivables due within a year. So it has liabilities totalling UK£13.4m more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of UK£14.4m. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution. Despite its noteworthy liabilities, reach4entertainment enterprises boasts net cash, so it's fair to say it does not have a heavy debt load!

Notably, reach4entertainment enterprises's EBIT launched higher than Elon Musk, gaining a whopping 1422% on last year. There's no doubt that we learn most about debt from the balance sheet. But it is reach4entertainment enterprises'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. While reach4entertainment enterprises 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. Over the last two years, reach4entertainment enterprises saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Summing up

Although reach4entertainment enterprises's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£31.0k. And we liked the look of last year's 1422% year-on-year EBIT growth. So while reach4entertainment enterprises does not have a great balance sheet, it's certainly not too bad. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Consider for instance, the ever-present spectre of investment risk. We've identified 3 warning signs with reach4entertainment enterprises , and understanding them should be part of your investment process.

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.

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.

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. Thank you for reading.