Here's Why Rio Paranapanema Energia (BVMF:GEPA3) Can Manage Its Debt Responsibly

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.' 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, Rio Paranapanema Energia S.A. (BVMF:GEPA3) does carry debt. But the more important question is: how much risk is that debt creating?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Rio Paranapanema Energia

What Is Rio Paranapanema Energia's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2021 Rio Paranapanema Energia had debt of R$1.51b, up from R$1.27b in one year. However, it does have R$331.1m in cash offsetting this, leading to net debt of about R$1.18b.

How Strong Is Rio Paranapanema Energia's Balance Sheet?

We can see from the most recent balance sheet that Rio Paranapanema Energia had liabilities of R$867.3m falling due within a year, and liabilities of R$1.29b due beyond that. Offsetting this, it had R$331.1m in cash and R$118.6m in receivables that were due within 12 months. So its liabilities total R$1.71b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Rio Paranapanema Energia has a market capitalization of R$3.04b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

Rio Paranapanema Energia has a low net debt to EBITDA ratio of only 0.84. And its EBIT easily covers its interest expense, being 24.7 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Rio Paranapanema Energia grew its EBIT by 127% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But it is Rio Paranapanema 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Rio Paranapanema Energia reported free cash flow worth 14% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

The good news is that Rio Paranapanema Energia's demonstrated ability to cover its interest expense with its EBIT delights us like a fluffy puppy does a toddler. But truth be told we feel its conversion of EBIT to free cash flow does undermine this impression a bit. It's also worth noting that Rio Paranapanema Energia is in the Electric Utilities industry, which is often considered to be quite defensive. All these things considered, it appears that Rio Paranapanema 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. But ultimately, every company can contain risks that exist outside of the balance sheet. For instance, we've identified 3 warning signs for Rio Paranapanema Energia (2 are concerning) you should be aware of.

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.

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.

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