Here's Why Companhia de Saneamento Básico do Estado de São Paulo - SABESP (BVMF:SBSP3) Has A Meaningful Debt Burden

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Companhia de Saneamento Básico do Estado de São Paulo - SABESP (BVMF:SBSP3) does use debt in its business. But is this debt a concern to shareholders?

When Is Debt A Problem?

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. 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 think about a company's use of debt, we first look at cash and debt together.

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

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

You can click the graphic below for the historical numbers, but it shows that as of September 2020 Companhia de Saneamento Básico do Estado de São Paulo - SABESP had R$14.9b of debt, an increase on R$13.0b, over one year. On the flip side, it has R$1.93b in cash leading to net debt of about R$13.0b.

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

We can see from the most recent balance sheet that Companhia de Saneamento Básico do Estado de São Paulo - SABESP had liabilities of R$4.22b falling due within a year, and liabilities of R$21.9b due beyond that. On the other hand, it had cash of R$1.93b and R$2.27b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$21.9b.

This is a mountain of leverage relative to its market capitalization of R$24.8b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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).

Companhia de Saneamento Básico do Estado de São Paulo - SABESP's net debt to EBITDA ratio of about 2.1 suggests only moderate use of debt. And its commanding EBIT of 12.0 times its interest expense, implies the debt load is as light as a peacock feather. Importantly, Companhia de Saneamento Básico do Estado de São Paulo - SABESP's EBIT fell a jaw-dropping 31% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. 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.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Companhia de Saneamento Básico do Estado de São Paulo - SABESP's free cash flow amounted to 29% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Companhia de Saneamento Básico do Estado de São Paulo - SABESP's EBIT growth rate was disappointing. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We should also note that Water Utilities industry companies like Companhia de Saneamento Básico do Estado de São Paulo - SABESP commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Companhia de Saneamento Básico do Estado de São Paulo - SABESP stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Companhia de Saneamento Básico do Estado de São Paulo - SABESP you should be aware of.

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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