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

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. Importantly, Companhia de Saneamento Básico do Estado de São Paulo - SABESP (BVMF:SBSP3) does carry debt. But is this debt a concern to shareholders?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt 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?

As you can see below, at the end of March 2023, Companhia de Saneamento Básico do Estado de São Paulo - SABESP had R$17.9b of debt, up from R$17.1b a year ago. Click the image for more detail. On the flip side, it has R$2.49b in cash leading to net debt of about R$15.4b.

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

According to the last reported balance sheet, Companhia de Saneamento Básico do Estado de São Paulo - SABESP had liabilities of R$6.16b due within 12 months, and liabilities of R$22.7b due beyond 12 months. Offsetting this, it had R$2.49b in cash and R$3.51b in receivables that were due within 12 months. So its liabilities total R$22.8b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of R$37.3b, so it does suggest shareholders should keep an eye on Companhia de Saneamento Básico do Estado de São Paulo - SABESP's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Companhia de Saneamento Básico do Estado de São Paulo - SABESP's net debt of 2.1 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 7.1 times its interest expenses harmonizes with that theme. If Companhia de Saneamento Básico do Estado de São Paulo - SABESP can keep growing EBIT at last year's rate of 19% over the last year, then it will find its debt load easier to manage. 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're focused on the future you can check out this free report showing analyst profit forecasts.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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 created free cash flow amounting to 8.5% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Companhia de Saneamento Básico do Estado de São Paulo - SABESP's conversion of EBIT to free cash flow and level of total liabilities definitely weigh on it, in our esteem. But its EBIT growth rate tells a very different story, and suggests some resilience. 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 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. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. When analysing debt levels, the balance sheet is the obvious place to start. 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 2 warning signs for Companhia de Saneamento Básico do Estado de São Paulo - SABESP you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.