Does Companhia Energética do Rio Grande do Norte - COSERN (BVMF:CSRN3) Have A Healthy Balance Sheet?

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 Energética do Rio Grande do Norte - COSERN (BVMF:CSRN3) makes use of debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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 Energética do Rio Grande do Norte - COSERN

How Much Debt Does Companhia Energética do Rio Grande do Norte - COSERN Carry?

The image below, which you can click on for greater detail, shows that at March 2023 Companhia Energética do Rio Grande do Norte - COSERN had debt of R$2.45b, up from R$2.11b in one year. However, because it has a cash reserve of R$280.0m, its net debt is less, at about R$2.17b.

A Look At Companhia Energética do Rio Grande do Norte - COSERN's Liabilities

The latest balance sheet data shows that Companhia Energética do Rio Grande do Norte - COSERN had liabilities of R$1.35b due within a year, and liabilities of R$2.55b falling due after that. Offsetting these obligations, it had cash of R$280.0m as well as receivables valued at R$825.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$2.80b.

This is a mountain of leverage relative to its market capitalization of R$3.86b. 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 Energética do Rio Grande do Norte - COSERN has net debt worth 1.9 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 6.1 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. We note that Companhia Energética do Rio Grande do Norte - COSERN grew its EBIT by 23% in the last year, and that should make it easier to pay down debt, going forward. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Companhia Energética do Rio Grande do Norte - COSERN will need earnings to service that debt. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Companhia Energética do Rio Grande do Norte - COSERN recorded free cash flow of 29% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis Companhia Energética do Rio Grande do Norte - COSERN's EBIT growth rate should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its level of total liabilities makes us a little nervous about its debt. It's also worth noting that Companhia Energética do Rio Grande do Norte - COSERN is in the Electric Utilities industry, which is often considered to be quite defensive. When we consider all the factors mentioned above, we do feel a bit cautious about Companhia Energética do Rio Grande do Norte - COSERN's use of debt. 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. For instance, we've identified 3 warning signs for Companhia Energética do Rio Grande do Norte - COSERN that you should be aware of.

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.