We Think EDP - Energias do Brasil (BVMF:ENBR3) Is Taking Some Risk With Its 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.' 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.

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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. When we examine debt levels, we first consider both cash and debt levels, together.

View our latest analysis for EDP - Energias do Brasil

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

You can click the graphic below for the historical numbers, but it shows that as of June 2021 EDP - Energias do Brasil had R$9.63b of debt, an increase on R$9.15b, over one year. However, it also had R$1.64b in cash, and so its net debt is R$7.99b.

How Strong 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$7.28b falling due within a year, and liabilities of R$12.8b due beyond that. On the other hand, it had cash of R$1.64b and R$3.27b worth of receivables due within a year. So it has liabilities totalling R$15.2b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of R$10.3b, 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.

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.

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 37.3 times its interest expense, implies the debt load is as light as a peacock feather. It is well worth noting that EDP - Energias do Brasil's EBIT shot up like bamboo after rain, gaining 39% in the last twelve months. That'll make it easier to manage its debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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 it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, EDP - Energias do Brasil reported free cash flow worth 9.4% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

We feel some trepidation about EDP - Energias do Brasil's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. It's also worth noting that EDP - Energias do Brasil is in the Electric Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think EDP - Energias do Brasil's debt poses some risks to the business. 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. To that end, you should be aware of the 2 warning signs we've spotted with EDP - Energias do Brasil .

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.
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