Companhia de Eletricidade do Estado da Bahia - COELBA (BVMF:CEEB3) Takes On Some Risk With Its Use Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. As with many other companies Companhia de Eletricidade do Estado da Bahia - COELBA (BVMF:CEEB3) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Companhia de Eletricidade do Estado da Bahia - COELBA

What Is Companhia de Eletricidade do Estado da Bahia - COELBA's Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Companhia de Eletricidade do Estado da Bahia - COELBA had debt of R$13.0b, up from R$9.22b in one year. However, it also had R$997.0m in cash, and so its net debt is R$12.0b.

How Healthy Is Companhia de Eletricidade do Estado da Bahia - COELBA's Balance Sheet?

According to the last reported balance sheet, Companhia de Eletricidade do Estado da Bahia - COELBA had liabilities of R$4.90b due within 12 months, and liabilities of R$14.7b due beyond 12 months. Offsetting this, it had R$997.0m in cash and R$4.15b in receivables that were due within 12 months. So its liabilities total R$14.5b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's R$10.2b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Companhia de Eletricidade do Estado da Bahia - COELBA's debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 4.8 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Importantly, Companhia de Eletricidade do Estado da Bahia - COELBA grew its EBIT by 54% over the last twelve months, and that growth will make it easier to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Companhia de Eletricidade do Estado da Bahia - COELBA's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Companhia de Eletricidade do Estado da Bahia - COELBA saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

On the face of it, Companhia de Eletricidade do Estado da Bahia - COELBA's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. It's also worth noting that Companhia de Eletricidade do Estado da Bahia - COELBA is in the Electric Utilities industry, which is often considered to be quite defensive. Overall, we think it's fair to say that Companhia de Eletricidade do Estado da Bahia - COELBA has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Companhia de Eletricidade do Estado da Bahia - COELBA (2 are concerning!) 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.

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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.