The external fund manager backed by Berkshire Hathaway’s Charlie Munger, Li Lu, makes no bones about it when he says ‘The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.’ When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that Portland General Electric Company (NYSE:POR) does have debt on its balance sheet. 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. Part and parcel of capitalism is the process of ‘creative destruction’ where failed businesses are mercilessly liquidated by their bankers. 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 think about a company’s use of debt, we first look at cash and debt together.
How Much Debt Does Portland General Electric Carry?
The chart below, which you can click on for greater detail, shows that Portland General Electric had US$2.39b in debt in June 2019; about the same as the year before. Net debt is about the same, since the it doesn’t have much cash.
How Strong Is Portland General Electric’s Balance Sheet?
According to the last reported balance sheet, Portland General Electric had liabilities of US$440.0m due within 12 months, and liabilities of US$5.02b due beyond 12 months. Offsetting this, it had US$11.0m in cash and US$222.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by US$5.22b.
Given this deficit is actually higher than the company’s market capitalization of US$4.93b, we think shareholders really should watch Portland General Electric’s debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.
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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.
While we wouldn’t worry about Portland General Electric’s net debt to EBITDA ratio of 3.3, we think its super-low interest cover of 2.4 times is a sign of high leverage. It seems that the business incurs large depreciation and amortisation charges, so maybe its debt load is heavier than it would first appear, since EBITDA is arguably a generous measure of earnings. So shareholders should probably be aware that interest expenses appear to have really impacted the business lately. Investors should also be troubled by the fact that Portland General Electric saw its EBIT drop by 12% over the last twelve months. If that’s the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Portland General Electric’s ability to maintain a healthy balance sheet going forward. So if you’re focused on the future you can check out this free report showing analyst profit forecasts.
Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Portland General Electric created free cash flow amounting to 11% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
To be frank both Portland General Electric’s EBIT growth rate and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. And furthermore, its conversion of EBIT to free cash flow also fails to instill confidence. It’s also worth noting that Portland General Electric is in the Electric Utilities industry, which is often considered to be quite defensive. We’re quite clear that we consider Portland General Electric to be really rather risky, as a result of its balance sheet health. For this reason we’re pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you’ve also come to that realization, you’re in luck, because today you can view this interactive graph of Portland General Electric’s earnings per share history for free.
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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If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. 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. Thank you for reading.