Is CPFL Energia (BVMF:CPFE3) A Risky Investment?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. Importantly, CPFL Energia S.A. (BVMF:CPFE3) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for CPFL Energia

How Much Debt Does CPFL Energia Carry?

You can click the graphic below for the historical numbers, but it shows that as of December 2022 CPFL Energia had R$28.5b of debt, an increase on R$25.0b, over one year. However, because it has a cash reserve of R$4.60b, its net debt is less, at about R$23.8b.

How Healthy Is CPFL Energia's Balance Sheet?

According to the last reported balance sheet, CPFL Energia had liabilities of R$14.9b due within 12 months, and liabilities of R$38.7b due beyond 12 months. Offsetting these obligations, it had cash of R$4.60b as well as receivables valued at R$7.83b due within 12 months. So it has liabilities totalling R$41.2b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of R$36.0b, 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 2.0 suggests only moderate use of debt. And its strong interest cover of 13.0 times, makes us even more comfortable. Importantly, CPFL Energia grew its EBIT by 41% 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 ultimately the future profitability of the business will decide if CPFL Energia can strengthen its balance sheet over time. 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 it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, CPFL Energia's free cash flow amounted to 35% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

CPFL Energia's interest cover was a real positive on this analysis, as was its EBIT growth rate. In contrast, our confidence was undermined by its apparent struggle to handle its total liabilities. It's also worth noting that CPFL Energia is in the Electric Utilities industry, which is often considered to be quite defensive. Looking at all this data makes us feel a little cautious about CPFL Energia's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. For example, we've discovered 2 warning signs for CPFL Energia that you should be aware of before investing here.

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.