Does EDP - Energias do Brasil (BVMF:ENBR3) 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that EDP - Energias do Brasil S.A. (BVMF:ENBR3) does use debt in its business. But should shareholders be worried about its use of debt?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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.

Check out our latest analysis for EDP - Energias do Brasil

How Much Debt Does EDP - Energias do Brasil Carry?

The image below, which you can click on for greater detail, shows that at September 2020 EDP - Energias do Brasil had debt of R$9.12b, up from R$8.75b in one year. However, because it has a cash reserve of R$3.31b, its net debt is less, at about R$5.81b.

How Healthy Is EDP - Energias do Brasil's Balance Sheet?

We can see from the most recent balance sheet that EDP - Energias do Brasil had liabilities of R$6.67b falling due within a year, and liabilities of R$10.9b due beyond that. On the other hand, it had cash of R$3.31b and R$3.53b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$10.7b.

This deficit is considerable relative to its market capitalization of R$11.4b, so it does suggest shareholders should keep an eye on EDP - Energias do Brasil'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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

EDP - Energias do Brasil's net debt to EBITDA ratio of about 2.0 suggests only moderate use of debt. And its commanding EBIT of 1k times its interest expense, implies the debt load is as light as a peacock feather. One way EDP - Energias do Brasil could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 16%, as it did over the last year. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine EDP - Energias do Brasil's ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, EDP - Energias do Brasil recorded free cash flow of 24% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

When it comes to the balance sheet, the standout positive for EDP - Energias do Brasil was the fact that it seems able to cover its interest expense with its EBIT confidently. However, our other observations weren't so heartening. For instance it seems like it has to struggle a bit to handle its total liabilities. We would also note that Electric Utilities industry companies like EDP - Energias do Brasil commonly do use debt without problems. Looking at all this data makes us feel a little cautious about EDP - Energias do Brasil's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. For instance, we've identified 2 warning signs for EDP - Energias do Brasil that you should be aware of.

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. 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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