Snam (BIT:SRG) Takes On Some Risk With Its Use Of Debt

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 Snam S.p.A. (BIT:SRG) does use debt in its business. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Snam

What Is Snam's Debt?

As you can see below, at the end of September 2019, Snam had €15.5b of debt, up from €13.7b a year ago. Click the image for more detail. However, because it has a cash reserve of €3.65b, its net debt is less, at about €11.9b.

How Healthy Is Snam's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Snam had liabilities of €6.21b due within 12 months and liabilities of €11.8b due beyond that. Offsetting these obligations, it had cash of €3.65b as well as receivables valued at €1.01b due within 12 months. So its liabilities total €13.4b more than the combination of its cash and short-term receivables.

This is a mountain of leverage even relative to its gargantuan market capitalization of €15.0b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Snam's net debt to EBITDA ratio is 5.5 which suggests rather high debt levels, but its interest cover of 9.4 times suggests the debt is easily serviced. Overall we'd say it seems likely the company is carrying a fairly heavy swag of debt. Snam grew its EBIT by 4.0% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. 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 Snam'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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Snam's free cash flow amounted to 47% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Snam's net debt to EBITDA was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. For example its interest cover was refreshing. It's also worth noting that Snam is in the Gas Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Snam's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. Another positive for shareholders is that it pays dividends. So if you like receiving those dividend payments, check Snam's dividend history, without delay!

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.

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