Is Companhiade Eletricidade do Estado da Bahia - COELBA (BVMF:CEEB3) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Companhiade Eletricidade do Estado da Bahia - COELBA (BVMF:CEEB3) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

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 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. 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 examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Companhiade Eletricidade do Estado da Bahia - COELBA

How Much Debt Does Companhiade Eletricidade do Estado da Bahia - COELBA Carry?

The image below, which you can click on for greater detail, shows that Companhiade Eletricidade do Estado da Bahia - COELBA had debt of R$7.83b at the end of December 2020, a reduction from R$9.00b over a year. However, it also had R$478.0m in cash, and so its net debt is R$7.35b.

A Look At Companhiade Eletricidade do Estado da Bahia - COELBA's Liabilities

We can see from the most recent balance sheet that Companhiade Eletricidade do Estado da Bahia - COELBA had liabilities of R$3.48b falling due within a year, and liabilities of R$11.3b due beyond that. Offsetting this, it had R$478.0m in cash and R$3.28b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$11.1b.

Given this deficit is actually higher than the company's market capitalization of R$10.5b, we think shareholders really should watch Companhiade Eletricidade do Estado da Bahia - COELBA's debt levels, like a parent watching their child ride a bike for the first time. 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).

Companhiade Eletricidade do Estado da Bahia - COELBA's net debt is 2.9 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 13.5 is very high, suggesting that the interest expense on the debt is currently quite low. One way Companhiade Eletricidade do Estado da Bahia - COELBA could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Companhiade Eletricidade do Estado da Bahia - COELBA'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 clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Companhiade Eletricidade do Estado da Bahia - COELBA burned a lot of cash. 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

We'd go so far as to say Companhiade Eletricidade do Estado da Bahia - COELBA's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. It's also worth noting that Companhiade Eletricidade do Estado da Bahia - COELBA is in the Electric Utilities industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that Companhiade Eletricidade do Estado da Bahia - COELBA's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 1 warning sign for Companhiade Eletricidade do Estado da Bahia - COELBA you should be aware of.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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