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

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 is this debt a concern to shareholders?

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. 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 Debt?

The image below, which you can click on for greater detail, shows that at March 2021 Companhia de Saneamento de Minas Gerais had debt of R$3.62b, up from R$3.35b in one year. On the flip side, it has R$941.2m in cash leading to net debt of about R$2.68b.

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$1.71b due within 12 months, and liabilities of R$3.54b due beyond 12 months. On the other hand, it had cash of R$941.2m and R$1.07b worth of receivables due within a year. So it has liabilities totalling R$3.23b more than its cash and near-term receivables, combined.

Companhia de Saneamento de Minas Gerais has a market capitalization of R$6.65b, 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.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Companhia de Saneamento de Minas Gerais has a low net debt to EBITDA ratio of only 1.4. And its EBIT easily covers its interest expense, being 45.8 times the size. So we're pretty relaxed about its super-conservative use of debt. Also good is that Companhia de Saneamento de Minas Gerais grew its EBIT at 13% over the last year, further increasing its ability to manage 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. 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 58% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Companhia de Saneamento de Minas Gerais's impressive interest cover implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. 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. Looking at all the aforementioned factors together, it strikes us that Companhia de Saneamento de Minas Gerais can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Companhia de Saneamento de Minas Gerais 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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