Is Companhia de Saneamento de Minas Gerais (BVMF:CSMG3) A Risky Investment?

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. 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 is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

View our latest analysis for Companhia de Saneamento de Minas Gerais

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

You can click the graphic below for the historical numbers, but it shows that as of September 2021 Companhia de Saneamento de Minas Gerais had R$3.99b of debt, an increase on R$3.33b, over one year. However, it does have R$1.46b in cash offsetting this, leading to net debt of about R$2.53b.

How Healthy 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$2.02b due within 12 months and liabilities of R$4.05b due beyond that. Offsetting this, it had R$1.46b in cash and R$1.19b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$3.42b.

This is a mountain of leverage relative to its market capitalization of R$4.52b. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Companhia de Saneamento de Minas Gerais has a low net debt to EBITDA ratio of only 1.4. And its EBIT covers its interest expense a whopping 10.2 times over. So we're pretty relaxed about its super-conservative use of debt. But the other side of the story is that Companhia de Saneamento de Minas Gerais saw its EBIT decline by 5.0% over the last year. If earnings continue to decline at that rate the company may have increasing difficulty managing its debt load. 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.

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. During the last three years, Companhia de Saneamento de Minas Gerais produced sturdy free cash flow equating to 66% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

Both Companhia de Saneamento de Minas Gerais's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. Having said that, its level of total liabilities somewhat sensitizes us to potential future risks to the balance sheet. We would also note that Water Utilities industry companies like Companhia de Saneamento de Minas Gerais commonly do use debt without problems. Looking at all this data makes us feel a little cautious about Companhia de Saneamento de Minas Gerais's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. Over time, share prices tend to follow earnings per share, so if you're interested in Companhia de Saneamento de Minas Gerais, you may well want to click here to check an interactive graph of its earnings per share history.

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.