Does Companhia de Saneamento Básico do Estado de São Paulo - SABESP (BVMF:SBSP3) Have A Healthy 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.' 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. Importantly, Companhia de Saneamento Básico do Estado de São Paulo - SABESP (BVMF:SBSP3) does carry debt. But the real question is whether this debt is making the company risky.

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Companhia de Saneamento Básico do Estado de São Paulo - SABESP

What Is Companhia de Saneamento Básico do Estado de São Paulo - SABESP's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 Companhia de Saneamento Básico do Estado de São Paulo - SABESP had R$18.3b of debt, an increase on R$17.2b, over one year. However, it does have R$2.26b in cash offsetting this, leading to net debt of about R$16.0b.

How Strong Is Companhia de Saneamento Básico do Estado de São Paulo - SABESP's Balance Sheet?

The latest balance sheet data shows that Companhia de Saneamento Básico do Estado de São Paulo - SABESP had liabilities of R$6.45b due within a year, and liabilities of R$22.3b falling due after that. Offsetting these obligations, it had cash of R$2.26b as well as receivables valued at R$3.65b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$22.8b.

While this might seem like a lot, it is not so bad since Companhia de Saneamento Básico do Estado de São Paulo - SABESP has a market capitalization of R$40.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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).

Companhia de Saneamento Básico do Estado de São Paulo - SABESP's net debt is sitting at a very reasonable 2.2 times its EBITDA, while its EBIT covered its interest expense just 6.8 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. We note that Companhia de Saneamento Básico do Estado de São Paulo - SABESP grew its EBIT by 22% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Companhia de Saneamento Básico do Estado de São Paulo - SABESP created free cash flow amounting to 3.8% 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 our analysis Companhia de Saneamento Básico do Estado de São Paulo - SABESP's EBIT growth rate should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. In particular, conversion of EBIT to free cash flow gives us cold feet. We would also note that Water Utilities industry companies like Companhia de Saneamento Básico do Estado de São Paulo - SABESP commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Companhia de Saneamento Básico do Estado de São Paulo - SABESP's use of debt. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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 Companhia de Saneamento Básico do Estado de São Paulo - SABESP .

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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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.