Is Companhia Energética do Rio Grande do Norte - COSERN (BVMF:CSRN3) Using Too Much Debt?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Companhia Energética do Rio Grande do Norte - COSERN (BVMF:CSRN3) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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 usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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

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 March 2022 Companhia Energética do Rio Grande do Norte - COSERN had R$2.11b of debt, an increase on R$1.87b, over one year. On the flip side, it has R$266.0m in cash leading to net debt of about R$1.85b.

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

Zooming in on the latest balance sheet data, we can see that Companhia Energética do Rio Grande do Norte - COSERN had liabilities of R$1.50b due within 12 months and liabilities of R$2.24b due beyond that. Offsetting these obligations, it had cash of R$266.0m as well as receivables valued at R$895.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$2.58b.

This deficit is considerable relative to its market capitalization of R$3.35b, so it does suggest shareholders should keep an eye on Companhia Energética do Rio Grande do Norte - COSERN's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). 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's net debt is sitting at a very reasonable 2.0 times its EBITDA, while its EBIT covered its interest expense just 6.4 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. It is well worth noting that Companhia Energética do Rio Grande do Norte - COSERN's EBIT shot up like bamboo after rain, gaining 59% in the last twelve months. That'll make it easier to manage its debt. 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, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Companhia Energética do Rio Grande do Norte - COSERN reported free cash flow worth 19% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay 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 instance it seems like it has to struggle a bit to convert EBIT to free cash flow. 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 we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Companhia Energética do Rio Grande do Norte - COSERN , and understanding them should be part of your investment process.

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.