We Think Equatorial Pará Distribuidora de Energia (BVMF:EQPA3) Can Stay On Top Of Its Debt

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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. Importantly, Equatorial Pará Distribuidora de Energia S.A. (BVMF:EQPA3) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt A Problem?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, plenty of companies use debt to fund growth, without any negative consequences. 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 Net Debt?

As you can see below, at the end of September 2021, Equatorial Pará Distribuidora de Energia had R$4.70b of debt, up from R$4.33b a year ago. Click the image for more detail. However, because it has a cash reserve of R$2.60b, its net debt is less, at about R$2.10b.

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

Zooming in on the latest balance sheet data, we can see that Equatorial Pará Distribuidora de Energia had liabilities of R$3.67b due within 12 months and liabilities of R$5.52b due beyond that. Offsetting these obligations, it had cash of R$2.60b as well as receivables valued at R$2.80b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$3.78b.

Equatorial Pará Distribuidora de Energia has a market capitalization of R$12.4b, so it could very likely raise cash to ameliorate 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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Equatorial Pará Distribuidora de Energia has net debt of just 1.1 times EBITDA, indicating that it is certainly not a reckless borrower. And this view is supported by the solid interest coverage, with EBIT coming in at 9.1 times the interest expense over the last year. Also positive, Equatorial Pará Distribuidora de Energia grew its EBIT by 28% in the last year, and that should make it easier to pay down debt, going forward. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Equatorial Pará Distribuidora de Energia recorded free cash flow worth 51% 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 grow its EBIT delights us like a fluffy puppy does a toddler. And that's just the beginning of the good news since its interest cover is also very heartening. 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. When we consider the range of factors above, it looks like Equatorial Pará Distribuidora de Energia is pretty sensible with its use of 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. However, not all investment risk resides within the balance sheet - far from it. Be aware that Equatorial Pará Distribuidora de Energia is showing 2 warning signs in our investment analysis , you should know about...

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.