Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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, Transmissora Aliança de Energia Elétrica S.A. (BVMF:TAEE11) does carry debt. But is this debt a concern to shareholders?
Why Does Debt Bring Risk?
Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Transmissora Aliança de Energia Elétrica Carry?
The image below, which you can click on for greater detail, shows that at September 2021 Transmissora Aliança de Energia Elétrica had debt of R$7.00b, up from R$6.62b in one year. However, it does have R$967.9m in cash offsetting this, leading to net debt of about R$6.03b.
How Healthy Is Transmissora Aliança de Energia Elétrica's Balance Sheet?
Zooming in on the latest balance sheet data, we can see that Transmissora Aliança de Energia Elétrica had liabilities of R$1.24b due within 12 months and liabilities of R$7.94b due beyond that. Offsetting this, it had R$967.9m in cash and R$1.41b in receivables that were due within 12 months. So it has liabilities totalling R$6.80b more than its cash and near-term receivables, combined.
While this might seem like a lot, it is not so bad since Transmissora Aliança de Energia Elétrica has a market capitalization of R$13.0b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without 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). 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).
With a debt to EBITDA ratio of 2.0, Transmissora Aliança de Energia Elétrica uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 8.1 times its interest expenses harmonizes with that theme. It is well worth noting that Transmissora Aliança de Energia Elétrica's EBIT shot up like bamboo after rain, gaining 68% in the last twelve months. That'll make it easier to manage its debt. When analysing debt levels, the balance sheet is the obvious place to start. 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.
Finally, a company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Transmissora Aliança de Energia Elétrica recorded free cash flow of 43% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.
Happily, Transmissora Aliança de Energia Elétrica's impressive EBIT growth rate implies it has the upper hand on its debt. But, on a more sombre note, we are a little concerned by its level of total liabilities. It's also worth noting that Transmissora Aliança de Energia Elétrica is in the Electric Utilities industry, which is often considered to be quite defensive. All these things considered, it appears that Transmissora Aliança de Energia Elétrica can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 3 warning signs for Transmissora Aliança de Energia Elétrica (2 are a bit concerning!) that you should be aware of before investing here.
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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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.