We Think Companhia de Saneamento de Minas Gerais (BVMF:CSMG3) Can Stay On Top Of Its Debt

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. 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 A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

See our latest analysis for Companhia de Saneamento de Minas Gerais

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

The chart below, which you can click on for greater detail, shows that Companhia de Saneamento de Minas Gerais had R$3.33b in debt in September 2020; about the same as the year before. However, because it has a cash reserve of R$1.10b, its net debt is less, at about R$2.23b.

A Look At Companhia de Saneamento de Minas Gerais' Liabilities

Zooming in on the latest balance sheet data, we can see that Companhia de Saneamento de Minas Gerais had liabilities of R$1.47b due within 12 months and liabilities of R$3.42b due beyond that. On the other hand, it had cash of R$1.10b and R$1.09b worth of receivables due within a year. So its liabilities total R$2.70b more than the combination of its cash and short-term receivables.

Companhia de Saneamento de Minas Gerais has a market capitalization of R$6.00b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Companhia de Saneamento de Minas Gerais's net debt is only 1.3 times its EBITDA. And its EBIT easily covers its interest expense, being 12.5 times the size. So we're pretty relaxed about its super-conservative use of debt. Another good sign is that Companhia de Saneamento de Minas Gerais has been able to increase its EBIT by 23% in twelve months, making it easier to pay down 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Companhia de Saneamento de Minas Gerais recorded free cash flow worth 56% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Companhia de Saneamento de Minas Gerais's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its level of total liabilities does undermine this impression a bit. We would also note that Water Utilities industry companies like Companhia de Saneamento de Minas Gerais commonly do use debt without problems. When we consider the range of factors above, it looks like Companhia de Saneamento de Minas Gerais is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. Be aware that Companhia de Saneamento de Minas Gerais is showing 2 warning signs in our investment analysis , you should know about...

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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