Equatorial Pará Distribuidora de Energia (BVMF:EQPA3) Has A Pretty Healthy Balance Sheet

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 Equatorial Pará Distribuidora de Energia S.A. (BVMF:EQPA3) does have debt on its balance sheet. But is this debt a concern to shareholders?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Equatorial Pará Distribuidora de Energia

How Much Debt Does Equatorial Pará Distribuidora de Energia Carry?

The image below, which you can click on for greater detail, shows that at March 2021 Equatorial Pará Distribuidora de Energia had debt of R$4.47b, up from R$3.77b in one year. However, it also had R$2.87b in cash, and so its net debt is R$1.60b.

A Look At Equatorial Pará Distribuidora de Energia's Liabilities

The latest balance sheet data shows that Equatorial Pará Distribuidora de Energia had liabilities of R$2.65b due within a year, and liabilities of R$6.47b falling due after that. On the other hand, it had cash of R$2.87b and R$2.34b worth of receivables due within a year. So it has liabilities totalling R$3.93b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Equatorial Pará Distribuidora de Energia has a market capitalization of R$11.7b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

While Equatorial Pará Distribuidora de Energia's low debt to EBITDA ratio of 1.0 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.3 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Also good is that Equatorial Pará Distribuidora de Energia grew its EBIT at 11% over the last year, further increasing its ability to manage debt. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Equatorial Pará Distribuidora de Energia will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Equatorial Pará Distribuidora de Energia recorded free cash flow worth 67% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Our View

The good news is that Equatorial Pará Distribuidora de Energia's demonstrated ability to convert EBIT to free cash flow delights us like a fluffy puppy does a toddler. And we also thought its net debt to EBITDA was a positive. It's also worth noting that Equatorial Pará Distribuidora de Energia is in the Electric Utilities industry, which is often considered to be quite defensive. Taking all this data into account, it seems to us that Equatorial Pará Distribuidora de Energia takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 3 warning signs for Equatorial Pará Distribuidora de Energia 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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