Warren Buffett famously said, ‘Volatility is far from synonymous with risk.’ It’s only natural to consider a company’s balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Elia System Operator SA (EBR:ELI) does carry debt. But the more important question is: how much risk is that debt creating?
When Is Debt Dangerous?
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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
How Much Debt Does Elia System Operator Carry?
As you can see below, Elia System Operator had €6.33b of debt at June 2019, down from €6.74b a year prior. However, because it has a cash reserve of €1.92b, its net debt is less, at about €4.40b.
How Healthy Is Elia System Operator’s Balance Sheet?
According to the last reported balance sheet, Elia System Operator had liabilities of €3.06b due within 12 months, and liabilities of €6.88b due beyond 12 months. On the other hand, it had cash of €1.92b and €460.9m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €7.56b.
The deficiency here weighs heavily on the €4.90b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. After all, Elia System Operator would likely require a major re-capitalisation if it had to pay its creditors today.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
Elia System Operator has a debt to EBITDA ratio of 5.0 and its EBIT covered its interest expense 4.8 times. Taken together this implies that, while we wouldn’t want to see debt levels rise, we think it can handle its current leverage. Notably, Elia System Operator’s EBIT launched higher than Elon Musk, gaining a whopping 114% on last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Elia System Operator can strengthen its balance sheet over time. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Elia System Operator burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.
On the face of it, Elia System Operator’s level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it’s pretty decent at growing its EBIT; that’s encouraging. We should also note that Electric Utilities industry companies like Elia System Operator commonly do use debt without problems. Overall, it seems to us that Elia System Operator’s balance sheet is really quite a risk to the business. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Over time, share prices tend to follow earnings per share, so if you’re interested in Elia System Operator, you may well want to click here to check an interactive graph of its earnings per share history.
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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