Is Equatorial Pará Distribuidora de Energia (BVMF:EQPA3) Using Too Much 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.' 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?

Why Does Debt Bring Risk?

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. 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, 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.

See our latest analysis for Equatorial Pará Distribuidora de Energia

What Is Equatorial Pará Distribuidora de Energia's Debt?

As you can see below, at the end of December 2022, Equatorial Pará Distribuidora de Energia had R$5.63b of debt, up from R$4.12b a year ago. Click the image for more detail. However, it does have R$1.68b in cash offsetting this, leading to net debt of about R$3.95b.

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

The latest balance sheet data shows that Equatorial Pará Distribuidora de Energia had liabilities of R$3.26b due within a year, and liabilities of R$6.64b falling due after that. On the other hand, it had cash of R$1.68b and R$2.51b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$5.71b.

This deficit isn't so bad because Equatorial Pará Distribuidora de Energia is worth R$14.4b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

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.

Equatorial Pará Distribuidora de Energia's net debt to EBITDA ratio of about 1.5 suggests only moderate use of debt. And its strong interest cover of 19.3 times, makes us even more comfortable. On top of that, Equatorial Pará Distribuidora de Energia grew its EBIT by 31% over the last twelve months, and that growth will make it easier to handle its debt. There's no doubt that we learn most about debt from the balance sheet. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Equatorial Pará Distribuidora de Energia reported free cash flow worth 19% 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

Equatorial Pará Distribuidora de Energia's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its conversion of EBIT to free cash flow 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. Looking at all the aforementioned factors together, it strikes us that Equatorial Pará Distribuidora de Energia can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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. Case in point: We've spotted 3 warning signs for Equatorial Pará Distribuidora de Energia you should be aware of, and 2 of them make us uncomfortable.

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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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.