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

Warren Buffett famously said, '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. Importantly, EDP - Energias do Brasil S.A. (BVMF:ENBR3) does carry debt. But the more important question is: how much risk is that debt creating?

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. If things get really bad, the lenders can take control of the business. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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 EDP - Energias do Brasil

What Is EDP - Energias do Brasil's Debt?

As you can see below, at the end of September 2021, EDP - Energias do Brasil had R$9.89b of debt, up from R$9.12b a year ago. Click the image for more detail. On the flip side, it has R$1.80b in cash leading to net debt of about R$8.09b.

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$8.60b due within 12 months and liabilities of R$12.7b due beyond that. Offsetting these obligations, it had cash of R$1.80b as well as receivables valued at R$3.90b due within 12 months. So it has liabilities totalling R$15.6b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's market capitalization of R$12.0b, 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 use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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 1.8 suggests only moderate use of debt. And its strong interest cover of 17.5 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 62% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs 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 4.9% 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. We think that EDP - Energias do Brasil's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. Case in point: We've spotted 2 warning signs for EDP - Energias do Brasil you should be aware of, and 1 of them is significant.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.