Engie Brasil Energia (BVMF:EGIE3) Takes On Some Risk With Its Use Of Debt

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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 the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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, plenty of companies use debt to fund growth, without any negative consequences. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out our latest analysis for Engie Brasil Energia

What Is Engie Brasil Energia's Net Debt?

As you can see below, Engie Brasil Energia had R$18.4b of debt at March 2023, down from R$21.5b a year prior. On the flip side, it has R$3.14b in cash leading to net debt of about R$15.3b.

A Look At Engie Brasil Energia's Liabilities

We can see from the most recent balance sheet that Engie Brasil Energia had liabilities of R$6.74b falling due within a year, and liabilities of R$23.6b due beyond that. On the other hand, it had cash of R$3.14b and R$1.81b worth of receivables due within a year. 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$36.2b, 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.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Engie Brasil Energia has a quite reasonable net debt to EBITDA multiple of 2.4, its interest cover seems weak, at 2.3. This does have us wondering if the company pays high interest because it is considered risky. In any case, it's safe to say the company has meaningful debt. Sadly, Engie Brasil Energia's EBIT actually dropped 6.1% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. 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 reported free cash flow worth 17% 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

We'd go so far as to say Engie Brasil Energia's interest cover was disappointing. But at least its net debt to EBITDA is not so bad. Overall, we think it's fair to say that Engie Brasil Energia has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Engie Brasil Energia you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.