Companhia de Saneamento Básico do Estado de São Paulo - SABESP (BVMF:SBSP3) Has A Somewhat Strained Balance Sheet

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. We note that Companhia de Saneamento Básico do Estado de São Paulo - SABESP (BVMF:SBSP3) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Our analysis indicates that SBSP3 is potentially undervalued!

How Much Debt Does Companhia de Saneamento Básico do Estado de São Paulo - SABESP Carry?

As you can see below, at the end of September 2022, Companhia de Saneamento Básico do Estado de São Paulo - SABESP had R$18.3b of debt, up from R$17.4b a year ago. Click the image for more detail. On the flip side, it has R$3.42b in cash leading to net debt of about R$14.9b.

A Look At Companhia de Saneamento Básico do Estado de São Paulo - SABESP's Liabilities

The latest balance sheet data shows that Companhia de Saneamento Básico do Estado de São Paulo - SABESP had liabilities of R$4.84b due within a year, and liabilities of R$23.8b falling due after that. Offsetting these obligations, it had cash of R$3.42b as well as receivables valued at R$3.34b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$21.9b.

This deficit isn't so bad because Companhia de Saneamento Básico do Estado de São Paulo - SABESP is worth R$41.5b, and thus could probably raise enough capital to shore up 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.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (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 a debt to EBITDA ratio of 2.3, Companhia de Saneamento Básico do Estado de São Paulo - SABESP uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 9.8 times its interest expenses harmonizes with that theme. Unfortunately, Companhia de Saneamento Básico do Estado de São Paulo - SABESP saw its EBIT slide 3.2% in the last twelve months. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Companhia de Saneamento Básico do Estado de São Paulo - SABESP can strengthen its balance sheet over time. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Companhia de Saneamento Básico do Estado de São Paulo - SABESP reported free cash flow worth 14% of its EBIT, which is really quite low. For us, cash conversion that low sparks a little paranoia about is ability to extinguish debt.

Our View

Neither Companhia de Saneamento Básico do Estado de São Paulo - SABESP's ability to convert EBIT to free cash flow nor its level of total liabilities gave us confidence in its ability to take on more debt. But the good news is it seems to be able to cover its interest expense with its EBIT with ease. It's also worth noting that Companhia de Saneamento Básico do Estado de São Paulo - SABESP is in the Water Utilities industry, which is often considered to be quite defensive. Looking at all the angles mentioned above, it does seem to us that Companhia de Saneamento Básico do Estado de São Paulo - SABESP is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Companhia de Saneamento Básico do Estado de São Paulo - SABESP 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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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.