Is Societatea Energetica Electrica (BVB:EL) A Risky Investment?

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. As with many other companies Societatea Energetica Electrica S.A. (BVB:EL) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Societatea Energetica Electrica

What Is Societatea Energetica Electrica's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Societatea Energetica Electrica had debt of RON3.87b, up from RON3.02b in one year. However, it also had RON187.6m in cash, and so its net debt is RON3.68b.

How Healthy Is Societatea Energetica Electrica's Balance Sheet?

We can see from the most recent balance sheet that Societatea Energetica Electrica had liabilities of RON5.56b falling due within a year, and liabilities of RON1.26b due beyond that. On the other hand, it had cash of RON187.6m and RON4.60b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by RON2.03b.

This deficit isn't so bad because Societatea Energetica Electrica is worth RON3.57b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Societatea Energetica Electrica has net debt worth 2.5 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 3.2 times the interest expense. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Pleasingly, Societatea Energetica Electrica is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 12,898% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Societatea Energetica Electrica's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Societatea Energetica Electrica 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.

Our View

Neither Societatea Energetica Electrica's ability to convert EBIT to free cash flow nor its interest cover gave us confidence in its ability to take on more debt. But the good news is it seems to be able to grow its EBIT with ease. It's also worth noting that Societatea Energetica Electrica is in the Electric Utilities industry, which is often considered to be quite defensive. Looking at all the angles mentioned above, it does seem to us that Societatea Energetica Electrica is a somewhat risky investment as a result of its debt. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. Be aware that Societatea Energetica Electrica is showing 1 warning sign in our investment analysis , you should know about...

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.