CPFL Energia (BVMF:CPFE3) Takes On Some Risk With Its Use Of Debt

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. Importantly, CPFL Energia S.A. (BVMF:CPFE3) does carry debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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 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 think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for CPFL Energia

How Much Debt Does CPFL Energia Carry?

As you can see below, at the end of June 2024, CPFL Energia had R$30.8b of debt, up from R$28.3b a year ago. Click the image for more detail. However, because it has a cash reserve of R$3.94b, its net debt is less, at about R$26.9b.

How Healthy Is CPFL Energia's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that CPFL Energia had liabilities of R$15.6b due within 12 months and liabilities of R$38.2b due beyond that. Offsetting these obligations, it had cash of R$3.94b as well as receivables valued at R$8.79b due within 12 months. So its liabilities total R$41.1b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of R$39.3b, we think shareholders really should watch CPFL Energia's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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.

CPFL Energia's net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its commanding EBIT of 10.8 times its interest expense, implies the debt load is as light as a peacock feather. Unfortunately, CPFL Energia saw its EBIT slide 4.0% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine CPFL Energia's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, CPFL Energia's free cash flow amounted to 30% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

CPFL Energia's level of total liabilities and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But its interest cover tells a very different story, and suggests some resilience. It's also worth noting that CPFL Energia is in the Electric Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think CPFL Energia's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for CPFL Energia (of which 1 is a bit unpleasant!) you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.