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.' 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. Importantly, CEZ Distribution Bulgaria AD (BUL:CEZD) does carry debt. But should shareholders be worried about its use of debt?
When Is Debt A Problem?
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. If things get really bad, the lenders can take control of the business. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is CEZ Distribution Bulgaria AD's Debt?
The image below, which you can click on for greater detail, shows that at December 2021 CEZ Distribution Bulgaria AD had debt of лв160.5m, up from лв146.5m in one year. However, because it has a cash reserve of лв14.3m, its net debt is less, at about лв146.2m.
A Look At CEZ Distribution Bulgaria AD's Liabilities
According to the last reported balance sheet, CEZ Distribution Bulgaria AD had liabilities of лв151.9m due within 12 months, and liabilities of лв165.9m due beyond 12 months. Offsetting these obligations, it had cash of лв14.3m as well as receivables valued at лв151.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by лв152.5m.
This deficit isn't so bad because CEZ Distribution Bulgaria AD is worth лв559.1m, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
CEZ Distribution Bulgaria AD's net debt is only 0.93 times its EBITDA. And its EBIT easily covers its interest expense, being 18.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that CEZ Distribution Bulgaria AD has boosted its EBIT by 48%, thus reducing the spectre of future debt repayments. When analysing debt levels, the balance sheet is the obvious place to start. But it is CEZ Distribution Bulgaria AD's earnings that will influence how the balance sheet holds up in the future. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.
Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Considering the last three years, CEZ Distribution Bulgaria AD actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.
CEZ Distribution Bulgaria AD's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But the stark truth is that we are concerned by its conversion of EBIT to free cash flow. It's also worth noting that CEZ Distribution Bulgaria AD is in the Electric Utilities industry, which is often considered to be quite defensive. All these things considered, it appears that CEZ Distribution Bulgaria AD can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. Over time, share prices tend to follow earnings per share, so if you're interested in CEZ Distribution Bulgaria AD, you may well want to click here to check an interactive graph of its earnings per share history.
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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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.