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

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.' 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. As with many other companies Engie Brasil Energia S.A. (BVMF:EGIE3) makes use of debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Engie Brasil Energia

How Much Debt Does Engie Brasil Energia Carry?

As you can see below, at the end of June 2024, Engie Brasil Energia had R$21.9b of debt, up from R$19.0b a year ago. Click the image for more detail. However, it does have R$4.31b in cash offsetting this, leading to net debt of about R$17.6b.

How Healthy Is Engie Brasil Energia's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Engie Brasil Energia had liabilities of R$6.40b due within 12 months and liabilities of R$28.0b due beyond that. Offsetting this, it had R$4.31b in cash and R$1.95b in receivables that were due within 12 months. So it has liabilities totalling R$28.1b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of R$35.7b. 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). 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).

Engie Brasil Energia's debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 3.1 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Fortunately, Engie Brasil Energia grew its EBIT by 4.6% in the last year, slowly shrinking its debt relative to earnings. 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. Over the last three years, Engie Brasil Energia reported free cash flow worth 18% 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

To be frank both Engie Brasil Energia's conversion of EBIT to free cash flow and its track record of covering its interest expense with its EBIT make us rather uncomfortable with its debt levels. But at least its EBIT growth rate is not so bad. 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. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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 example, we've discovered 4 warning signs for Engie Brasil Energia (3 are concerning!) that you should be aware of before investing here.

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.

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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.