Companhia de Saneamento de Minas Gerais (BVMF:CSMG3) Has A Pretty Healthy Balance Sheet

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.' 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, Companhia de Saneamento de Minas Gerais (BVMF:CSMG3) 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Companhia de Saneamento de Minas Gerais

How Much Debt Does Companhia de Saneamento de Minas Gerais Carry?

The image below, which you can click on for greater detail, shows that at June 2021 Companhia de Saneamento de Minas Gerais had debt of R$3.46b, up from R$3.29b in one year. However, it also had R$881.5m in cash, and so its net debt is R$2.58b.

How Strong Is Companhia de Saneamento de Minas Gerais' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Companhia de Saneamento de Minas Gerais had liabilities of R$1.57b due within 12 months and liabilities of R$3.53b due beyond that. Offsetting this, it had R$881.5m in cash and R$1.09b in receivables that were due within 12 months. So its liabilities total R$3.12b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Companhia de Saneamento de Minas Gerais is worth R$5.34b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). 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).

Companhia de Saneamento de Minas Gerais has a low net debt to EBITDA ratio of only 1.3. And its EBIT easily covers its interest expense, being 14.6 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. And we also note warmly that Companhia de Saneamento de Minas Gerais grew its EBIT by 20% last year, making its debt load easier to handle. 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 Companhia de Saneamento de Minas Gerais can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Companhia de Saneamento de Minas Gerais produced sturdy free cash flow equating to 60% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Companhia de Saneamento de Minas Gerais's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. We would also note that Water Utilities industry companies like Companhia de Saneamento de Minas Gerais commonly do use debt without problems. When we consider the range of factors above, it looks like Companhia de Saneamento de Minas Gerais is pretty sensible with its use of debt. While that brings some risk, it can also enhance returns for shareholders. 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. We've identified 2 warning signs with Companhia de Saneamento de Minas Gerais , and understanding them should be part of your investment process.

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.

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.

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