Here's Why Equatorial Pará Distribuidora de Energia (BVMF:EQPA3) Can Manage Its Debt Responsibly

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.' 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. Importantly, Equatorial Pará Distribuidora de Energia S.A. (BVMF:EQPA3) does carry debt. 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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

Check out 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 September 2020 Equatorial Pará Distribuidora de Energia had debt of R$4.33b, up from R$3.59b in one year. On the flip side, it has R$2.59b in cash leading to net debt of about R$1.73b.

How Strong Is Equatorial Pará Distribuidora de Energia's Balance Sheet?

According to the last reported balance sheet, Equatorial Pará Distribuidora de Energia had liabilities of R$2.03b due within 12 months, and liabilities of R$6.83b due beyond 12 months. On the other hand, it had cash of R$2.59b and R$2.37b worth of receivables due within a year. So it has liabilities totalling R$3.90b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Equatorial Pará Distribuidora de Energia is worth R$8.96b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Looking at its net debt to EBITDA of 1.1 and interest cover of 6.4 times, it seems to us that Equatorial Pará Distribuidora de Energia is probably using debt in a pretty reasonable way. So we'd recommend keeping a close eye on the impact financing costs are having on the business. Also positive, Equatorial Pará Distribuidora de Energia grew its EBIT by 30% in the last year, and that should make it easier to pay down debt, going forward. The balance sheet is clearly the area to focus on when you are analysing debt. 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, Equatorial Pará Distribuidora de Energia recorded free cash flow of 47% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

The good news is that Equatorial Pará Distribuidora de Energia's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its level of total liabilities does undermine this impression a bit. We would also note that Electric Utilities industry companies like Equatorial Pará Distribuidora de Energia commonly do use debt without problems. All these things considered, it appears that Equatorial Pará Distribuidora de Energia can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. For example, we've discovered 1 warning sign for Equatorial Pará Distribuidora de Energia that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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