Equatorial Energia (BVMF:EQTL3) Takes On Some Risk With Its Use Of 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. As with many other companies Equatorial Energia S.A. (BVMF:EQTL3) makes use of debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. 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 Energia

What Is Equatorial Energia's Net Debt?

The chart below, which you can click on for greater detail, shows that Equatorial Energia had R$17.2b in debt in September 2020; about the same as the year before. However, it also had R$7.02b in cash, and so its net debt is R$10.2b.

How Healthy Is Equatorial Energia's Balance Sheet?

The latest balance sheet data shows that Equatorial Energia had liabilities of R$7.67b due within a year, and liabilities of R$22.9b falling due after that. On the other hand, it had cash of R$7.02b and R$6.36b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$17.2b.

This is a mountain of leverage relative to its market capitalization of R$22.3b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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 Energia's net debt is sitting at a very reasonable 1.8 times its EBITDA, while its EBIT covered its interest expense just 6.1 times last year. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. It is well worth noting that Equatorial Energia's EBIT shot up like bamboo after rain, gaining 35% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Equatorial Energia can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Equatorial Energia recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Neither Equatorial Energia's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. We should also note that Electric Utilities industry companies like Equatorial Energia commonly do use debt without problems. We think that Equatorial Energia's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 example, we've discovered 1 warning sign for Equatorial Energia that you should be aware of before investing here.

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.

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