Rio Paranapanema Energia (BVMF:GEPA3) Seems To Use Debt Quite Sensibly

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We note that Rio Paranapanema Energia S.A. (BVMF:GEPA3) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own 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.

Check out our latest analysis for Rio Paranapanema Energia

How Much Debt Does Rio Paranapanema Energia Carry?

You can click the graphic below for the historical numbers, but it shows that Rio Paranapanema Energia had R$1.04b of debt in September 2020, down from R$1.34b, one year before. However, it also had R$1.03b in cash, and so its net debt is R$8.41m.

A Look At Rio Paranapanema Energia's Liabilities

According to the last reported balance sheet, Rio Paranapanema Energia had liabilities of R$1.73b due within 12 months, and liabilities of R$805.9m due beyond 12 months. Offsetting these obligations, it had cash of R$1.03b as well as receivables valued at R$199.7m due within 12 months. So it has liabilities totalling R$1.31b more than its cash and near-term receivables, combined.

Rio Paranapanema Energia has a market capitalization of R$3.73b, so it could very likely raise cash to ameliorate 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. But either way, Rio Paranapanema Energia has virtually no net debt, so it's fair to say it does not have a heavy debt load!

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).

With debt at a measly 0.011 times EBITDA and EBIT covering interest a whopping 19.4 times, it's clear that Rio Paranapanema Energia is not a desperate borrower. Indeed relative to its earnings its debt load seems light as a feather. But the other side of the story is that Rio Paranapanema Energia saw its EBIT decline by 4.2% over the last year. That sort of decline, if sustained, will obviously make debt harder to handle. 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.

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. Over the last three years, Rio Paranapanema Energia recorded free cash flow worth a fulsome 97% of its EBIT, which is stronger than we'd usually expect. That puts it in a very strong position to pay down debt.

Our View

Happily, Rio Paranapanema Energia's impressive interest cover implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its EBIT growth rate. It's also worth noting that Rio Paranapanema Energia is in the Electric Utilities industry, which is often considered to be quite defensive. When we consider the range of factors above, it looks like Rio Paranapanema Energia is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Rio Paranapanema Energia has 2 warning signs we think you should be aware of.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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