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

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. As with many other companies Engie Brasil Energia S.A. (BVMF:EGIE3) makes use of debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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.

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 June 2022 Engie Brasil Energia had R$21.4b of debt, an increase on R$19.1b, over one year. On the flip side, it has R$4.31b in cash leading to net debt of about R$17.1b.

How Healthy Is Engie Brasil Energia's Balance Sheet?

The latest balance sheet data shows that Engie Brasil Energia had liabilities of R$5.59b due within a year, and liabilities of R$26.1b falling due after that. Offsetting these obligations, it had cash of R$4.31b as well as receivables valued at R$1.99b due within 12 months. So its liabilities total R$25.4b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of R$32.2b, so it does suggest shareholders should keep an eye on Engie Brasil Energia's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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.

While Engie Brasil Energia has a quite reasonable net debt to EBITDA multiple of 2.4, its interest cover seems weak, at 1.7. This does have us wondering if the company pays high interest because it is considered risky. Either way there's no doubt the stock is using meaningful leverage. Engie Brasil Energia grew its EBIT by 6.9% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Engie Brasil Energia can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept 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, Engie Brasil Energia's free cash flow amounted to 22% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

We'd go so far as to say Engie Brasil Energia's interest cover was disappointing. But at least it's pretty decent at growing its EBIT; that's encouraging. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Engie Brasil Energia stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. To that end, you should learn about the 3 warning signs we've spotted with Engie Brasil Energia (including 2 which are concerning) .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.