Is Companhia de Saneamento Básico do Estado de São Paulo - SABESP (BVMF:SBSP3) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 can see that Companhia de Saneamento Básico do Estado de São Paulo - SABESP (BVMF:SBSP3) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. 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.

View 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 June 2022, Companhia de Saneamento Básico do Estado de São Paulo - SABESP had R$17.2b of debt, up from R$16.0b a year ago. Click the image for more detail. However, it also had R$2.61b in cash, and so its net debt is R$14.6b.

How Strong 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$4.78b falling due within a year, and liabilities of R$22.9b due beyond that. Offsetting these obligations, it had cash of R$2.61b as well as receivables valued at R$3.24b due within 12 months. So its liabilities total R$21.8b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of R$33.6b. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

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 alluring interest cover (EBIT of 8.6 times interest expense) certainly does not do anything to dispel this impression. Unfortunately, Companhia de Saneamento Básico do Estado de São Paulo - SABESP saw its EBIT slide 4.0% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. 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 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 14% of its EBIT, an uninspiring performance. For us, cash conversion that low sparks a little paranoia about is ability to extinguish 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 it seems to be able to cover its interest expense with its EBIT without much trouble. 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. When we consider all the factors discussed, it seems to us that Companhia de Saneamento Básico do Estado de São Paulo - SABESP is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Be aware that Companhia de Saneamento Básico do Estado de São Paulo - SABESP is showing 2 warning signs in our investment analysis , 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.

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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.