Rio Paranapanema Energia (BVMF:GEPA3) Has A Somewhat Strained Balance Sheet

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that '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, 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 assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

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 December 2021 Rio Paranapanema Energia had debt of R$1.29b, up from R$1.07b in one year. However, because it has a cash reserve of R$185.0m, its net debt is less, at about R$1.11b.

How Strong Is Rio Paranapanema Energia's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Rio Paranapanema Energia had liabilities of R$993.4m due within 12 months and liabilities of R$1.06b due beyond that. Offsetting this, it had R$185.0m in cash and R$190.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$1.68b.

This deficit is considerable relative to its market capitalization of R$2.47b, so it does suggest shareholders should keep an eye on Rio Paranapanema Energia's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

While Rio Paranapanema Energia has a quite reasonable net debt to EBITDA multiple of 2.5, its interest cover seems weak, at 1.1. The main reason for this is that it has such high depreciation and amortisation. These charges may be non-cash, so they could be excluded when it comes to paying down debt. But the accounting charges are there for a reason -- some assets are seen to be losing value. In any case, it's safe to say the company has meaningful debt. Shareholders should be aware that Rio Paranapanema Energia's EBIT was down 88% last year. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Rio Paranapanema Energia will need earnings to service that debt. 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Rio Paranapanema Energia created free cash flow amounting to 12% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

On the face of it, Rio Paranapanema Energia's interest cover left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its net debt to EBITDA is not so bad. We should also note that Electric Utilities industry companies like Rio Paranapanema Energia commonly do use debt without problems. Overall, it seems to us that Rio Paranapanema Energia's balance sheet is really quite a risk to the business. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. 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 1 warning sign for Rio Paranapanema Energia that you should be aware of.

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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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.