We Think EDP - Energias do Brasil (BVMF:ENBR3) Can Stay On Top Of Its 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.' 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. We note that EDP - Energias do Brasil S.A. (BVMF:ENBR3) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See our latest analysis for EDP - Energias do Brasil

What Is EDP - Energias do Brasil's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2021 EDP - Energias do Brasil had debt of R$10.0b, up from R$8.49b in one year. On the flip side, it has R$3.13b in cash leading to net debt of about R$6.87b.

A Look At EDP - Energias do Brasil's Liabilities

Zooming in on the latest balance sheet data, we can see that EDP - Energias do Brasil had liabilities of R$6.75b due within 12 months and liabilities of R$12.7b due beyond that. On the other hand, it had cash of R$3.13b and R$3.61b worth of receivables due within a year. So its liabilities total R$12.7b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of R$10.9b, we think shareholders really should watch EDP - Energias do Brasil's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

EDP - Energias do Brasil's net debt to EBITDA ratio of about 1.8 suggests only moderate use of debt. And its strong interest cover of 87.5 times, makes us even more comfortable. It is well worth noting that EDP - Energias do Brasil's EBIT shot up like bamboo after rain, gaining 32% in the last twelve months. That'll make it easier to manage its 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 EDP - Energias do Brasil 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 always check how much of that EBIT is translated into free cash flow. In the last three years, EDP - Energias do Brasil created free cash flow amounting to 18% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

EDP - Energias do Brasil's interest cover was a real positive on this analysis, as was its EBIT growth rate. But truth be told its level of total liabilities had us nibbling our nails. It's also worth noting that EDP - Energias do Brasil is in the Electric Utilities industry, which is often considered to be quite defensive. When we consider all the factors mentioned above, we do feel a bit cautious about EDP - Energias do Brasil's use of debt. 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.

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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