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. 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?

Why Does Debt Bring Risk?

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. 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, 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.

Check out our latest analysis for Equatorial Pará Distribuidora de Energia

What Is Equatorial Pará Distribuidora de Energia's Debt?

The image below, which you can click on for greater detail, shows that at September 2023 Equatorial Pará Distribuidora de Energia had debt of R$5.32b, up from R$4.23b in one year. However, it does have R$1.62b in cash offsetting this, leading to net debt of about R$3.70b.

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

We can see from the most recent balance sheet that Equatorial Pará Distribuidora de Energia had liabilities of R$3.32b falling due within a year, and liabilities of R$6.56b due beyond that. Offsetting this, it had R$1.62b in cash and R$3.17b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$5.10b.

This deficit isn't so bad because Equatorial Pará Distribuidora de Energia is worth R$18.2b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Equatorial Pará Distribuidora de Energia's net debt is only 1.1 times its EBITDA. And its EBIT easily covers its interest expense, being 16.0 times the size. So we're pretty relaxed about its super-conservative use of debt. On top of that, Equatorial Pará Distribuidora de Energia grew its EBIT by 42% over the last twelve months, and that growth will make it easier to handle its debt. When analysing debt levels, the balance sheet is the obvious place to start. But it is Equatorial Pará Distribuidora de Energia's earnings that will influence how the balance sheet holds up in the future. 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 always check how much of that EBIT is translated into free cash flow. In the last three years, Equatorial Pará Distribuidora de Energia created free cash flow amounting to 2.8% of its EBIT, an uninspiring performance. 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 the stark truth is that we are concerned by its conversion of EBIT to free cash flow. 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. 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. For instance, we've identified 3 warning signs for Equatorial Pará Distribuidora de Energia (1 is a bit unpleasant) you should be aware of.

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.