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 might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. 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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

See 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 2023 Equatorial Pará Distribuidora de Energia had debt of R$5.32b, up from R$4.23b in one year. However, because it has a cash reserve of R$1.62b, its net debt is less, at about R$3.70b.

A Look At Equatorial Pará Distribuidora de Energia's Liabilities

The latest balance sheet data shows that Equatorial Pará Distribuidora de Energia had liabilities of R$3.32b due within a year, and liabilities of R$6.56b falling due after that. Offsetting these obligations, it had cash of R$1.62b as well as receivables valued at R$3.17b 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$16.6b, 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 covers its interest expense a whopping 16.0 times over. So we're pretty relaxed about its super-conservative use of debt. In addition to that, we're happy to report that Equatorial Pará Distribuidora de Energia has boosted its EBIT by 42%, thus reducing the spectre of future debt repayments. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual 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

The good news is that Equatorial Pará Distribuidora de Energia's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. 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. 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 3 warning signs for Equatorial Pará Distribuidora de Energia (1 shouldn't be ignored) you should be aware of.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.