Is Engie Brasil Energia (BVMF:EGIE3) Using Too Much Debt?

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?

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first step when considering a company's debt levels is to consider 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 December 2021 Engie Brasil Energia had R$20.8b of debt, an increase on R$17.4b, over one year. However, because it has a cash reserve of R$5.16b, its net debt is less, at about R$15.6b.

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$5.78b falling due within a year, and liabilities of R$24.4b due beyond that. On the other hand, it had cash of R$5.16b and R$1.75b worth of receivables due within a year. So its liabilities total R$23.3b 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.

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 1.8. This does suggest the company is paying fairly high interest rates. Either way there's no doubt the stock is using meaningful leverage. We saw Engie Brasil Energia grow its EBIT by 7.5% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. 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 we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Engie Brasil Energia recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Mulling over Engie Brasil Energia's attempt at covering its interest expense with its EBIT, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. Once we consider all the factors above, together, it seems to us that Engie Brasil Energia's debt is making it 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. These risks can be hard to spot. Every company has them, and we've spotted 4 warning signs for Engie Brasil Energia (of which 2 make us uncomfortable!) you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.