Does Companhia de Saneamento de Minas Gerais (BVMF:CSMG3) Have A Healthy Balance Sheet?

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.' 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. As with many other companies Companhia de Saneamento de Minas Gerais (BVMF:CSMG3) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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, 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out 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 March 2024 Companhia de Saneamento de Minas Gerais had R$4.60b of debt, an increase on R$4.06b, over one year. However, because it has a cash reserve of R$783.6m, its net debt is less, at about R$3.82b.

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

According to the last reported balance sheet, Companhia de Saneamento de Minas Gerais had liabilities of R$1.92b due within 12 months, and liabilities of R$4.47b due beyond 12 months. Offsetting this, it had R$783.6m in cash and R$1.31b in receivables that were due within 12 months. So its liabilities total R$4.30b more than the combination of its cash and short-term receivables.

Companhia de Saneamento de Minas Gerais has a market capitalization of R$7.47b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Companhia de Saneamento de Minas Gerais's net debt to EBITDA ratio of about 1.5 suggests only moderate use of debt. And its strong interest cover of 11.5 times, makes us even more comfortable. Also good is that Companhia de Saneamento de Minas Gerais grew its EBIT at 18% over the last year, further increasing its ability to manage debt. 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'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. In the last three years, Companhia de Saneamento de Minas Gerais created free cash flow amounting to 14% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

When it comes to the balance sheet, the standout positive for Companhia de Saneamento de Minas Gerais was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to convert EBIT to free cash flow. 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. Considering this range of data points, we think Companhia de Saneamento de Minas Gerais 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. However, not all investment risk resides within the balance sheet - far from it. To that end, you should learn about the 3 warning signs we've spotted with Companhia de Saneamento de Minas Gerais (including 1 which is a bit unpleasant) .

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.