Is AGL Energy (ASX:AGL) Using Too Much Debt?

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.' 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 AGL Energy Limited (ASX:AGL) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for AGL Energy

What Is AGL Energy's Debt?

The image below, which you can click on for greater detail, shows that AGL Energy had debt of AU$2.45b at the end of December 2023, a reduction from AU$3.02b over a year. However, because it has a cash reserve of AU$152.0m, its net debt is less, at about AU$2.30b.

How Strong Is AGL Energy's Balance Sheet?

We can see from the most recent balance sheet that AGL Energy had liabilities of AU$3.44b falling due within a year, and liabilities of AU$5.58b due beyond that. On the other hand, it had cash of AU$152.0m and AU$1.65b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by AU$7.22b.

When you consider that this deficiency exceeds the company's AU$5.76b market capitalization, you might well be inclined to review the balance sheet intently. 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.

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).

AGL Energy's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 6.1 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. Importantly, AGL Energy's EBIT fell a jaw-dropping 39% 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 ultimately the future profitability of the business will decide if AGL Energy 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.

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. During the last three years, AGL Energy produced sturdy free cash flow equating to 50% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

We'd go so far as to say AGL Energy's EBIT growth rate was disappointing. But at least its interest cover is not so bad. It's also worth noting that AGL Energy is in the Integrated Utilities industry, which is often considered to be quite defensive. Overall, we think it's fair to say that AGL Energy has enough debt that there are some real risks around the balance sheet. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for AGL Energy that you should be aware of before investing here.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.