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

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. 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 Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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 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

How Much Debt Does EDP - Energias do Brasil Carry?

As you can see below, at the end of December 2021, EDP - Energias do Brasil had R$10.6b of debt, up from R$9.03b a year ago. Click the image for more detail. However, it does have R$2.71b in cash offsetting this, leading to net debt of about R$7.89b.

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

According to the last reported balance sheet, EDP - Energias do Brasil had liabilities of R$6.99b due within 12 months, and liabilities of R$14.1b due beyond 12 months. Offsetting this, it had R$2.71b in cash and R$4.09b in receivables that were due within 12 months. So its liabilities total R$14.3b 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$13.4b, 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 2.0 suggests only moderate use of debt. And its strong interest cover of 10.9 times, makes us even more comfortable. If EDP - Energias do Brasil can keep growing EBIT at last year's rate of 17% over the last year, then it will find its debt load easier to manage. 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 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, EDP - Energias do Brasil reported free cash flow worth 2.3% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Neither EDP - Energias do Brasil's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. 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. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with EDP - Energias do Brasil (including 2 which can't be ignored) .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.