Is Engie Brasil Energia (BVMF:EGIE3) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, Engie Brasil Energia S.A. (BVMF:EGIE3) does carry debt. But is this debt a concern to shareholders?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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

How Much Debt Does Engie Brasil Energia Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2021 Engie Brasil Energia had R$19.1b of debt, an increase on R$17.1b, over one year. However, because it has a cash reserve of R$5.40b, its net debt is less, at about R$13.7b.

How Strong Is Engie Brasil Energia's Balance Sheet?

We can see from the most recent balance sheet that Engie Brasil Energia had liabilities of R$5.71b falling due within a year, and liabilities of R$23.9b due beyond that. Offsetting these obligations, it had cash of R$5.40b as well as receivables valued at R$1.65b due within 12 months. So its liabilities total R$22.6b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of R$32.1b, 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.

Even though Engie Brasil Energia's debt is only 2.1, its interest cover is really very low at 1.9. This does suggest the company is paying fairly high interest rates. Either way there's no doubt the stock is using meaningful leverage. Also relevant is that Engie Brasil Energia has grown its EBIT by a very respectable 28% in the last year, thus enhancing its ability to pay down debt. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Engie Brasil Energia created free cash flow amounting to 18% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Engie Brasil Energia's interest cover and conversion of EBIT to free cash flow definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with Engie Brasil Energia (at least 1 which is a bit concerning) , and understanding them should be part of your investment process.

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.
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