These 4 Measures Indicate That Equatorial Pará Distribuidora de Energia (BVMF:EQPA3) Is Using Debt Reasonably Well

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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Equatorial Pará Distribuidora de Energia S.A. (BVMF:EQPA3) makes use of debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Equatorial Pará Distribuidora de Energia

What Is Equatorial Pará Distribuidora de Energia's Net Debt?

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. However, because it has a cash reserve of R$2.59b, its net debt is less, at about R$1.73b.

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$2.03b falling due within a year, and liabilities of R$6.83b due beyond that. Offsetting this, it had R$2.59b in cash and R$2.37b in receivables that were due within 12 months. So it has liabilities totalling R$3.90b more than its cash and near-term receivables, combined.

Equatorial Pará Distribuidora de Energia has a market capitalization of R$7.19b, so it could very likely raise cash to ameliorate 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

While Equatorial Pará Distribuidora de Energia's low debt to EBITDA ratio of 1.1 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 6.4 times last year does give us pause. 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 it is Equatorial Pará Distribuidora de Energia's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

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. 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's not great, when it comes to paying down debt.

Our View

Equatorial Pará Distribuidora de Energia's EBIT growth rate suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But, on a more sombre note, we are a little concerned by its level of total liabilities. 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. 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. 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. Be aware that Equatorial Pará Distribuidora de Energia is showing 1 warning sign in our investment analysis , you should know about...

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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