Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Companhia Energética do Rio Grande do Norte - COSERN (BVMF:CSRN3) does have debt on its balance sheet. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.
What Is Companhia Energética do Rio Grande do Norte - COSERN's Debt?
As you can see below, Companhia Energética do Rio Grande do Norte - COSERN had R$1.71b of debt, at December 2020, which is about the same as the year before. You can click the chart for greater detail. However, because it has a cash reserve of R$234.0m, its net debt is less, at about R$1.47b.
How Strong Is Companhia Energética do Rio Grande do Norte - COSERN's Balance Sheet?
We can see from the most recent balance sheet that Companhia Energética do Rio Grande do Norte - COSERN had liabilities of R$666.0m falling due within a year, and liabilities of R$2.62b due beyond that. On the other hand, it had cash of R$234.0m and R$748.0m worth of receivables due within a year. So it has liabilities totalling R$2.31b more than its cash and near-term receivables, combined.
This is a mountain of leverage relative to its market capitalization of R$2.68b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
With net debt to EBITDA of 2.5 Companhia Energética do Rio Grande do Norte - COSERN has a fairly noticeable amount of debt. But the high interest coverage of 9.8 suggests it can easily service that debt. If Companhia Energética do Rio Grande do Norte - COSERN can keep growing EBIT at last year's rate of 11% over the last year, then it will find its debt load easier to manage. 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Companhia Energética do Rio Grande do Norte - COSERN reported free cash flow worth 11% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.
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 the good news is it seems to be able to cover its interest expense with its EBIT with ease. We should also note that Electric Utilities industry companies like Companhia Energética do Rio Grande do Norte - COSERN commonly do use debt without problems. Looking at all the angles mentioned above, it does seem to us that Companhia Energética do Rio Grande do Norte - COSERN is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Case in point: We've spotted 2 warning signs for Companhia Energética do Rio Grande do Norte - COSERN you should be aware of.
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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