These 4 Measures Indicate That Equatorial Energia (BVMF:EQTL3) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Equatorial Energia S.A. (BVMF:EQTL3) does carry debt. But the real question is whether this debt is making the company risky.

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. 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, 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. 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?

As you can see below, Equatorial Energia had R$17.1b of debt, at March 2021, which is about the same as the year before. You can click the chart for greater detail. However, it does have R$6.81b in cash offsetting this, leading to net debt of about R$10.3b.

How Healthy Is Equatorial Energia's Balance Sheet?

The latest balance sheet data shows that Equatorial Energia had liabilities of R$7.09b due within a year, and liabilities of R$23.1b falling due after that. On the other hand, it had cash of R$6.81b and R$6.88b worth of receivables due within a year. So its liabilities total R$16.5b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of R$24.0b. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Equatorial Energia's net debt of 1.9 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 7.2 times its interest expenses harmonizes with that theme. Sadly, Equatorial Energia's EBIT actually dropped 6.8% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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, 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. Considering the last three years, Equatorial Energia actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

We'd go so far as to say Equatorial Energia's conversion of EBIT to free cash flow was disappointing. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We should also note that Electric Utilities industry companies like Equatorial Energia commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Equatorial Energia stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. To that end, you should be aware of the 2 warning signs we've spotted with Equatorial Energia .

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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