Howard Marks said it well when he said that, rather than worrying about stock price volatility, “the possibility of permanent loss is the risk I worry about…and that every practical investor that I know is worried”. So it may be obvious that you need to take debt into account when thinking about the risk of a given stock, because too much debt can sink a business. We note that Reka Industrial Oyj (HEL:REKA) has debt on its balance sheet. But should shareholders worry about its use of debt?

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. Although not too common, we often see companies in debt permanently diluting their shareholders because lenders force them to raise capital at a ridiculous price. That said, the most common situation is when a company manages its debt reasonably well – and to its own benefit. The first step when considering a company’s debt levels is to consider its cash and debt together.

See our latest review for Reka Industrial Oyj

What is Reka Industrial Oyj’s net debt?

As you can see below, Reka Industrial Oyj had a debt of 20.9 million euros in December 2021, compared to 25.6 million euros the previous year. On the other hand, he has €767.0k in cash, resulting in a net debt of around €20.2m.

How healthy is Reka Industrial Oyj’s balance sheet?

The latest balance sheet data shows that Reka Industrial Oyj had debts of EUR 32.9 million maturing within the year and debts of EUR 29.2 million maturing thereafter. On the other hand, it had cash of €767.0 K and €4.78 million in receivables at less than one year. Its liabilities therefore total €56.6 million more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the 21.9 million euro enterprise itself, like a child struggling under the weight of a huge backpack full of books, his sports equipment and a trumpet. So we definitely think shareholders need to watch this one closely. Ultimately, Reka Industrial Oyj would likely need a significant recapitalization if its creditors demanded repayment.

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). Thus, we consider debt to earnings with and without depreciation and amortization charges.

While Reka Industrial Oyj has a quite reasonable net debt to EBITDA ratio of 2.4, its interest coverage looks low at 2.4. This leads us to wonder if the company is paying high interest because it is considered risky. Regardless, there is no doubt that the stock uses significant leverage. Importantly, Reka Industrial Oyj has increased its EBIT by 45% over the last twelve months, and this growth will make it easier to manage its debt. When analyzing debt levels, the balance sheet is the obvious starting point. But it is future earnings, more than anything, that will determine Reka Industrial Oyj’s ability to maintain a healthy balance sheet in the future. So if you want to see what the professionals think, you might find this free analyst earnings forecast report interesting.

But our last consideration is also important, because a company cannot pay debt with paper profits; he needs cash. We must therefore clearly examine whether this EBIT generates a corresponding free cash flow. Over the last three years, Reka Industrial Oyj has recorded a free cash flow of 45% of its EBIT, which is lower than expected. That’s not great when it comes to paying off debt.

Our point of view

Reflecting on Reka Industrial Oyj’s attempt to rein in its total liabilities, we are certainly not enthusiastic. But at least it’s decent enough to increase its EBIT; it’s encouraging. Once we consider all the above factors together, it seems to us that Reka Industrial Oyj’s debt makes it a bit risky. Some people like that kind of risk, but we’re aware of the potential pitfalls, so we’d probably prefer it to take on less debt. The balance sheet is clearly the area to focus on when analyzing debt. However, not all investment risks reside on the balance sheet, far from it. We have identified 3 warning signs with Reka Industrial Oyj (at least 1 which is concerning), 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% freeright now.

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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.