Is Companhia Energética do Rio Grande do Norte - COSERN (BVMF:CSRN3) A Risky Investment?

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 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. We can see that Companhia Energética do Rio Grande do Norte - COSERN (BVMF:CSRN3) does use debt in its business. 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 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

Check out 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 December 2022 Companhia Energética do Rio Grande do Norte - COSERN had R$2.44b of debt, an increase on R$2.14b, over one year. However, it does have R$256.0m in cash offsetting this, leading to net debt of about R$2.18b.

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$1.16b due within 12 months and liabilities of R$2.70b due beyond that. Offsetting these obligations, it had cash of R$256.0m as well as receivables valued at R$830.0m due within 12 months. So its liabilities total R$2.78b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Companhia Energética do Rio Grande do Norte - COSERN has a market capitalization of R$4.66b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). 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 2.1 times its EBITDA, while its EBIT covered its interest expense just 6.7 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Also relevant is that Companhia Energética do Rio Grande do Norte - COSERN has grown its EBIT by a very respectable 25% in the last year, thus enhancing its ability to pay down debt. There's no doubt that we learn most about debt from the balance sheet. But it is Companhia Energética do Rio Grande do Norte - COSERN's earnings that will influence how the balance sheet holds up in the future. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Companhia Energética do Rio Grande do Norte - COSERN's free cash flow amounted to 30% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

When it comes to the balance sheet, the standout positive for Companhia Energética do Rio Grande do Norte - COSERN was the fact that it seems able to grow its EBIT confidently. However, our other observations weren't so heartening. 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 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 2 warning signs for Companhia Energética do Rio Grande do Norte - COSERN that you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.