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

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 AGL Energy Limited (ASX:AGL) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for AGL Energy

How Much Debt Does AGL Energy Carry?

As you can see below, AGL Energy had AU$2.48b of debt at June 2024, down from AU$2.65b a year prior. On the flip side, it has AU$962.0m in cash leading to net debt of about AU$1.52b.

A Look At AGL Energy's Liabilities

Zooming in on the latest balance sheet data, we can see that AGL Energy had liabilities of AU$4.56b due within 12 months and liabilities of AU$5.67b due beyond that. Offsetting this, it had AU$962.0m in cash and AU$2.20b in receivables that were due within 12 months. So its liabilities total AU$7.06b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of AU$7.30b, so it does suggest shareholders should keep an eye on AGL Energy's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

AGL Energy has a low net debt to EBITDA ratio of only 0.77. And its EBIT covers its interest expense a whopping 11.6 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Better yet, AGL Energy grew its EBIT by 143% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if AGL Energy can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, AGL Energy recorded free cash flow worth 63% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, AGL Energy's impressive EBIT growth rate implies it has the upper hand on its debt. But the stark truth is that we are concerned by its level of total liabilities. It's also worth noting that AGL Energy is in the Integrated Utilities industry, which is often considered to be quite defensive. Taking all this data into account, it seems to us that AGL Energy takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with AGL Energy (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.

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.

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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.