Is AGL Energy (ASX:AGL) A Risky Investment?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. As with many other companies AGL Energy Limited (ASX:AGL) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for AGL Energy

How Much Debt Does AGL Energy Carry?

The chart below, which you can click on for greater detail, shows that AGL Energy had AU$2.89b in debt in December 2020; about the same as the year before. However, it does have AU$101.0m in cash offsetting this, leading to net debt of about AU$2.79b.

How Healthy Is AGL Energy's Balance Sheet?

According to the last reported balance sheet, AGL Energy had liabilities of AU$3.14b due within 12 months, and liabilities of AU$6.78b due beyond 12 months. Offsetting these obligations, it had cash of AU$101.0m as well as receivables valued at AU$1.74b due within 12 months. So it has liabilities totalling AU$8.08b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of AU$6.04b, we think shareholders really should watch AGL Energy's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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).

With a debt to EBITDA ratio of 1.8, AGL Energy uses debt artfully but responsibly. And the alluring interest cover (EBIT of 8.4 times interest expense) certainly does not do anything to dispel this impression. Importantly, AGL Energy's EBIT fell a jaw-dropping 30% in the last twelve months. If that earnings trend continues then paying off its debt will be about as easy as herding cats on to a roller coaster. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine AGL Energy'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. Over the most recent three years, AGL Energy recorded free cash flow worth 80% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both AGL Energy's level of total liabilities and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We should also note that Integrated Utilities industry companies like AGL Energy commonly do use debt without problems. Once we consider all the factors above, together, it seems to us that AGL Energy's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. For example AGL Energy has 3 warning signs (and 1 which shouldn't be ignored) we think you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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. 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.
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