Does Engie Brasil Energia (BVMF:EGIE3) Have A Healthy Balance Sheet?

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. We note that Engie Brasil Energia S.A. (BVMF:EGIE3) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Engie Brasil Energia

What Is Engie Brasil Energia's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Engie Brasil Energia had R$18.6b of debt, an increase on R$14.0b, over one year. On the flip side, it has R$6.00b in cash leading to net debt of about R$12.6b.

A Look At Engie Brasil Energia's Liabilities

The latest balance sheet data shows that Engie Brasil Energia had liabilities of R$5.88b due within a year, and liabilities of R$21.4b falling due after that. Offsetting these obligations, it had cash of R$6.00b as well as receivables valued at R$1.90b due within 12 months. So its liabilities total R$19.4b more than the combination of its cash and short-term receivables.

This deficit isn't so bad because Engie Brasil Energia is worth R$35.3b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Engie Brasil Energia's net debt is sitting at a very reasonable 2.4 times its EBITDA, while its EBIT covered its interest expense just 2.7 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 Engie Brasil Energia could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 17%, as it did over the last year. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Engie Brasil Energia can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Engie Brasil Energia barely recorded positive free cash flow, in total. Some might say that's a concern, when it comes considering how easily it would be for it to down debt.

Our View

While Engie Brasil Energia's interest cover makes us cautious about it, its track record of converting EBIT to free cash flow is no better. But its not so bad at growing its EBIT. When we consider all the factors discussed, it seems to us that Engie Brasil Energia is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Engie Brasil Energia (1 is concerning!) that you should be aware of before investing here.

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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