These 4 Measures Indicate That Companhia de Saneamento de Minas Gerais (BVMF:CSMG3) Is Using Debt Reasonably Well

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 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 is this debt a concern to shareholders?

When Is Debt A Problem?

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. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. 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 2024 Companhia de Saneamento de Minas Gerais had R$6.16b of debt, an increase on R$4.60b, over one year. On the flip side, it has R$1.09b in cash leading to net debt of about R$5.07b.

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$1.50b due within 12 months and liabilities of R$5.99b due beyond that. Offsetting these obligations, it had cash of R$1.09b as well as receivables valued at R$1.31b due within 12 months. So it has liabilities totalling R$5.09b 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$8.51b, 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.

With a debt to EBITDA ratio of 1.8, Companhia de Saneamento de Minas Gerais uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 7.4 times its interest expenses harmonizes with that theme. Also relevant is that Companhia de Saneamento de Minas Gerais has grown its EBIT by a very respectable 29% in the last year, thus enhancing its ability to pay down 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 always check how much of that EBIT is translated into free cash flow. In the last three years, Companhia de Saneamento de Minas Gerais created free cash flow amounting to 3.4% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish 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 grow its EBIT confidently. However, our other observations weren't so heartening. To be specific, it seems about as good at converting EBIT to free cash flow as wet socks are at keeping your feet warm. 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 debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. To that end, you should learn about the 3 warning signs we've spotted with Companhia de Saneamento de Minas Gerais (including 1 which makes us a bit uncomfortable) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.