Is CPFL Energia (BVMF:CPFE3) Using Too Much 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.' 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. We can see that CPFL Energia S.A. (BVMF:CPFE3) does use debt in its business. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for CPFL Energia

What Is CPFL Energia's Net Debt?

The image below, which you can click on for greater detail, shows that at December 2021 CPFL Energia had debt of R$25.0b, up from R$21.3b in one year. However, it does have R$2.79b in cash offsetting this, leading to net debt of about R$22.2b.

How Healthy Is CPFL Energia's Balance Sheet?

We can see from the most recent balance sheet that CPFL Energia had liabilities of R$12.9b falling due within a year, and liabilities of R$36.4b due beyond that. On the other hand, it had cash of R$2.79b and R$8.56b worth of receivables due within a year. So its liabilities total R$38.0b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of R$38.3b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

CPFL Energia has a debt to EBITDA ratio of 2.5, which signals significant debt, but is still pretty reasonable for most types of business. However, its interest coverage of 29.7 is very high, suggesting that the interest expense on the debt is currently quite low. It is well worth noting that CPFL Energia's EBIT shot up like bamboo after rain, gaining 44% in the last twelve months. That'll make it easier to manage 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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, CPFL Energia recorded free cash flow of 45% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Both CPFL Energia's ability to to cover its interest expense with its EBIT and its EBIT growth rate gave us comfort that it can handle its debt. On the other hand, its level of total liabilities makes us a little less comfortable about its debt. We would also note that Electric Utilities industry companies like CPFL Energia commonly do use debt without problems. Considering this range of data points, we think CPFL Energia is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Case in point: We've spotted 4 warning signs for CPFL Energia you should be aware of, and 2 of them can't be ignored.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.