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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. As with many other companies Companhia de Saneamento de Minas Gerais (BVMF:CSMG3) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

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 thing to do when considering how much debt a business uses is to look at 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?

The image below, which you can click on for greater detail, shows that at September 2023 Companhia de Saneamento de Minas Gerais had debt of R$4.60b, up from R$3.44b in one year. However, it does have R$1.25b in cash offsetting this, leading to net debt of about R$3.35b.

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$1.71b due within 12 months and liabilities of R$4.41b due beyond that. Offsetting this, it had R$1.25b in cash and R$1.25b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$3.63b.

This deficit isn't so bad because Companhia de Saneamento de Minas Gerais is worth R$6.55b, and thus could probably raise enough capital to shore up 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). 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 1.5. And its EBIT easily covers its interest expense, being 20.9 times the size. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Companhia de Saneamento de Minas Gerais has boosted its EBIT by 32%, thus reducing the spectre of future debt repayments. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

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. Looking at the most recent three years, Companhia de Saneamento de Minas Gerais recorded free cash flow of 23% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

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, on a more sombre note, we are a little concerned by its conversion of 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. All these things considered, it appears that Companhia de Saneamento de Minas Gerais can comfortably handle its current debt levels. 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. 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 3 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.