Here's Why Companhia Energética do Rio Grande do Norte - COSERN (BVMF:CSRN3) Has A Meaningful Debt Burden

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. As with many other companies Companhia Energética do Rio Grande do Norte - COSERN (BVMF:CSRN3) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Companhia Energética do Rio Grande do Norte - COSERN

What Is Companhia Energética do Rio Grande do Norte - COSERN's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Companhia Energética do Rio Grande do Norte - COSERN had R$2.56b of debt, an increase on R$2.19b, over one year. However, it does have R$404.0m in cash offsetting this, leading to net debt of about R$2.15b.

How Strong Is Companhia Energética do Rio Grande do Norte - COSERN's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Companhia Energética do Rio Grande do Norte - COSERN had liabilities of R$1.71b due within 12 months and liabilities of R$2.43b due beyond that. Offsetting these obligations, it had cash of R$404.0m as well as receivables valued at R$887.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$2.84b.

This deficit is considerable relative to its market capitalization of R$4.49b, so it does suggest shareholders should keep an eye on Companhia Energética do Rio Grande do Norte - COSERN's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Companhia Energética do Rio Grande do Norte - COSERN's net debt is sitting at a very reasonable 1.9 times its EBITDA, while its EBIT covered its interest expense just 5.8 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. One way Companhia Energética do Rio Grande do Norte - COSERN could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 14%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. 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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Companhia Energética do Rio Grande do Norte - COSERN recorded free cash flow of 25% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Neither Companhia Energética do Rio Grande do Norte - COSERN's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But we do take some comfort from its EBIT growth rate. We should also note that Electric Utilities industry companies like Companhia Energética do Rio Grande do Norte - COSERN commonly do use debt without problems. We think that Companhia Energética do Rio Grande do Norte - COSERN's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. For example, we've discovered 3 warning signs for Companhia Energética do Rio Grande do Norte - COSERN (1 is potentially serious!) that you should be aware of before investing here.

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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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.