Companhia de Saneamento de Minas Gerais (BVMF:CSMG3) Has A Somewhat Strained Balance Sheet

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. We can see that Companhia de Saneamento de Minas Gerais (BVMF:CSMG3) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

See our latest analysis for Companhia de Saneamento de Minas Gerais

What Is Companhia de Saneamento de Minas Gerais's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2022 Companhia de Saneamento de Minas Gerais had debt of R$3.72b, up from R$3.46b in one year. However, it also had R$789.3m in cash, and so its net debt is R$2.93b.

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$1.76b due within 12 months and liabilities of R$3.70b due beyond that. On the other hand, it had cash of R$789.3m and R$1.08b worth of receivables due within a year. So it has liabilities totalling R$3.60b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of R$5.34b, so it does suggest shareholders should keep an eye on Companhia de Saneamento de Minas Gerais' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

Companhia de Saneamento de Minas Gerais has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 3.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Worse, Companhia de Saneamento de Minas Gerais's EBIT was down 41% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Companhia de Saneamento de Minas Gerais'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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Companhia de Saneamento de Minas Gerais's free cash flow amounted to 49% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over Companhia de Saneamento de Minas Gerais's attempt at (not) growing its EBIT, we're certainly not enthusiastic. Having said that, its ability to convert EBIT to free cash flow isn't such a worry. We should also note that Water Utilities industry companies like Companhia de Saneamento de Minas Gerais commonly do use debt without problems. Once we consider all the factors above, together, it seems to us that Companhia de Saneamento de Minas Gerais'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. 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. For example - Companhia de Saneamento de Minas Gerais has 3 warning signs we think 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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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.