Companhia de Saneamento de Minas Gerais (BVMF:CSMG3) Seems To Use Debt Quite Sensibly

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 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. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for Companhia de Saneamento de Minas Gerais

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

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Companhia de Saneamento de Minas Gerais had R$3.99b of debt, an increase on R$3.72b, over one year. On the flip side, it has R$740.6m in cash leading to net debt of about R$3.25b.

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

We can see from the most recent balance sheet that Companhia de Saneamento de Minas Gerais had liabilities of R$2.01b falling due within a year, and liabilities of R$3.90b due beyond that. On the other hand, it had cash of R$740.6m and R$1.44b worth of receivables due within a year. So it has liabilities totalling R$3.74b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Companhia de Saneamento de Minas Gerais has a market capitalization of R$7.03b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Looking at its net debt to EBITDA of 1.5 and interest cover of 5.9 times, it seems to us that Companhia de Saneamento de Minas Gerais is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. It is well worth noting that Companhia de Saneamento de Minas Gerais's EBIT shot up like bamboo after rain, gaining 73% in the last twelve months. That'll make it easier to manage its debt. There's no doubt that we learn most about debt from the balance sheet. 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're focused on the future you can check out this free report showing analyst profit forecasts.

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. In the last three years, Companhia de Saneamento de Minas Gerais's free cash flow amounted to 29% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

On our analysis Companhia de Saneamento de Minas Gerais's EBIT growth rate should signal that it won't have too much trouble with its debt. However, our other observations weren't so heartening. For example, its conversion of EBIT to free cash flow makes us a little nervous about its debt. It's also worth noting that Companhia de Saneamento de Minas Gerais is in the Water Utilities industry, which is often considered to be quite defensive. When we consider all the elements mentioned above, it seems to us that Companhia de Saneamento de Minas Gerais is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Companhia de Saneamento de Minas Gerais (1 doesn't sit too well with us) you should be aware of.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.