Is Transmissora Aliança de Energia Elétrica (BVMF:TAEE11) Using Too Much Debt?

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. As with many other companies Transmissora Aliança de Energia Elétrica S.A. (BVMF:TAEE11) makes use of debt. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

View our latest analysis for Transmissora Aliança de Energia Elétrica

What Is Transmissora Aliança de Energia Elétrica's Net Debt?

The image below, which you can click on for greater detail, shows that at March 2022 Transmissora Aliança de Energia Elétrica had debt of R$7.68b, up from R$6.46b in one year. However, it does have R$1.45b in cash offsetting this, leading to net debt of about R$6.22b.

How Healthy Is Transmissora Aliança de Energia Elétrica's Balance Sheet?

We can see from the most recent balance sheet that Transmissora Aliança de Energia Elétrica had liabilities of R$1.43b falling due within a year, and liabilities of R$8.72b due beyond that. Offsetting these obligations, it had cash of R$1.45b as well as receivables valued at R$1.87b due within 12 months. So its liabilities total R$6.82b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Transmissora Aliança de Energia Elétrica has a market capitalization of R$14.1b, and so it could probably strengthen its balance sheet by raising capital if it needed to. However, it is still worthwhile taking a close look at its ability to pay off debt.

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).

Transmissora Aliança de Energia Elétrica has net debt worth 2.3 times EBITDA, which isn't too much, but its interest cover looks a bit on the low side, with EBIT at only 5.9 times the interest expense. While that doesn't worry us too much, it does suggest the interest payments are somewhat of a burden. Transmissora Aliança de Energia Elétrica grew its EBIT by 2.8% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Transmissora Aliança de Energia Elétrica 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. Looking at the most recent three years, Transmissora Aliança de Energia Elétrica recorded free cash flow of 44% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We weren't impressed with Transmissora Aliança de Energia Elétrica's net debt to EBITDA, and its level of total liabilities made us cautious. Balancing that a bit, it has a demonstrated ability interest cover. We would also note that Electric Utilities industry companies like Transmissora Aliança de Energia Elétrica commonly do use debt without problems. When we consider all the factors mentioned above, we do feel a bit cautious about Transmissora Aliança de Energia Elétrica's use of debt. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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. To that end, you should learn about the 3 warning signs we've spotted with Transmissora Aliança de Energia Elétrica (including 1 which is significant) .

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.