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

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that EDP - Energias do Brasil S.A. (BVMF:ENBR3) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we think about a company's use of debt, we first look at cash and debt 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 March 2022 EDP - Energias do Brasil had R$12.5b of debt, an increase on R$10.0b, over one year. However, because it has a cash reserve of R$2.72b, its net debt is less, at about R$9.80b.

A Look At EDP - Energias do Brasil's Liabilities

According to the last reported balance sheet, EDP - Energias do Brasil had liabilities of R$7.28b due within 12 months, and liabilities of R$16.5b due beyond 12 months. On the other hand, it had cash of R$2.72b and R$4.08b worth of receivables due within a year. So it has liabilities totalling R$17.0b 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. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

With a debt to EBITDA ratio of 2.3, EDP - Energias do Brasil uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 7.0 times its interest expenses harmonizes with that theme. If EDP - Energias do Brasil can keep growing EBIT at last year's rate of 13% over the last year, then it will find its debt load easier to manage. 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.

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 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

On the face of it, EDP - Energias do Brasil's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Electric Utilities industry companies like EDP - Energias do Brasil commonly do use debt without problems. Overall, we think it's fair to say that EDP - Energias do Brasil has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. Be aware that EDP - Energias do Brasil is showing 2 warning signs in our investment analysis , you should know about...

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.