We Think Rio Paranapanema Energia (BVMF:GEPA3) Can Stay On Top Of Its Debt

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. As with many other companies Rio Paranapanema Energia S.A. (BVMF:GEPA3) makes use of debt. But the more important question is: how much risk is that debt creating?

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.

View our latest analysis for Rio Paranapanema Energia

What Is Rio Paranapanema Energia's Net Debt?

As you can see below, Rio Paranapanema Energia had R$1.07b of debt at December 2020, down from R$1.37b a year prior. But on the other hand it also has R$1.11b in cash, leading to a R$39.9m net cash position.

A Look At Rio Paranapanema Energia's Liabilities

Zooming in on the latest balance sheet data, we can see that Rio Paranapanema Energia had liabilities of R$2.96b due within 12 months and liabilities of R$844.9m due beyond that. Offsetting these obligations, it had cash of R$1.11b as well as receivables valued at R$843.7m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$1.85b.

Rio Paranapanema Energia has a market capitalization of R$3.48b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution. Despite its noteworthy liabilities, Rio Paranapanema Energia boasts net cash, so it's fair to say it does not have a heavy debt load!

Better yet, Rio Paranapanema Energia grew its EBIT by 188% last year, which is an impressive improvement. 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. Rio Paranapanema Energia may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. Over the most recent three years, Rio Paranapanema Energia recorded free cash flow worth 60% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.

Summing up

While Rio Paranapanema Energia does have more liabilities than liquid assets, it also has net cash of R$39.9m. And it impressed us with its EBIT growth of 188% over the last year. So is Rio Paranapanema Energia's debt a risk? It doesn't seem so to us. 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 Rio Paranapanema Energia .

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.

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