These 4 Measures Indicate That Neoenergia (BVMF:NEOE3) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Neoenergia S.A. (BVMF:NEOE3) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Neoenergia

How Much Debt Does Neoenergia Carry?

As you can see below, at the end of December 2020, Neoenergia had R$26.5b of debt, up from R$22.7b a year ago. Click the image for more detail. However, it does have R$5.08b in cash offsetting this, leading to net debt of about R$21.4b.

A Look At Neoenergia's Liabilities

We can see from the most recent balance sheet that Neoenergia had liabilities of R$12.0b falling due within a year, and liabilities of R$32.8b due beyond that. On the other hand, it had cash of R$5.08b and R$8.47b worth of receivables due within a year. So its liabilities total R$31.2b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the R$19.4b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Neoenergia would likely require a major re-capitalisation if it had to pay its creditors today.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Neoenergia has net debt to EBITDA of 3.2 suggesting it uses a fair bit of leverage to boost returns. On the plus side, its EBIT was 7.8 times its interest expense, and its net debt to EBITDA, was quite high, at 3.2. One way Neoenergia could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 15%, as it did over the last year. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Neoenergia's ability to maintain a healthy balance sheet going forward. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Neoenergia burned a lot of cash. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, Neoenergia's conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Electric Utilities industry companies like Neoenergia commonly do use debt without problems. We're quite clear that we consider Neoenergia to be really rather risky, as a result of its balance sheet health. 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. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Neoenergia (of which 1 is a bit concerning!) you should know about.

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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