The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 CEZ Distribution Bulgaria AD (BUL:CEZD) makes use of debt. But the real question is whether this debt is making the company risky.
When Is Debt Dangerous?
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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does CEZ Distribution Bulgaria AD Carry?
You can click the graphic below for the historical numbers, but it shows that CEZ Distribution Bulgaria AD had лв142.2m of debt in September 2020, down from лв168.7m, one year before. On the flip side, it has лв61.7m in cash leading to net debt of about лв80.5m.
How Healthy Is CEZ Distribution Bulgaria AD's Balance Sheet?
We can see from the most recent balance sheet that CEZ Distribution Bulgaria AD had liabilities of лв174.1m falling due within a year, and liabilities of лв128.8m due beyond that. Offsetting this, it had лв61.7m in cash and лв55.4m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by лв185.8m.
While this might seem like a lot, it is not so bad since CEZ Distribution Bulgaria AD has a market capitalization of лв516.7m, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
CEZ Distribution Bulgaria AD's net debt is only 0.59 times its EBITDA. And its EBIT covers its interest expense a whopping 41.7 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. On top of that, CEZ Distribution Bulgaria AD grew its EBIT by 63% over the last twelve months, and that growth will make it easier to handle its debt. 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, CEZ Distribution Bulgaria AD recorded negative free cash flow, in total. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.
Happily, CEZ Distribution Bulgaria AD's impressive interest cover implies it has the upper hand on its debt. 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. Above most other metrics, we think its important to track how fast earnings per share is growing, if at all. If you've also come to that realization, you're in luck, because today you can view this interactive graph of CEZ Distribution Bulgaria AD's earnings per share history for free.
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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