These 4 Measures Indicate That Transmissora Aliança de Energia Elétrica (BVMF:TAEE11) Is Using Debt Extensively

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Transmissora Aliança de Energia Elétrica

What Is Transmissora Aliança de Energia Elétrica's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Transmissora Aliança de Energia Elétrica had R$8.63b of debt, an increase on R$6.80b, over one year. However, it also had R$1.84b in cash, and so its net debt is R$6.78b.

How Strong 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$1.28b falling due within a year, and liabilities of R$9.80b due beyond that. Offsetting these obligations, it had cash of R$1.84b as well as receivables valued at R$1.95b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$7.28b.

Transmissora Aliança de Energia Elétrica has a market capitalization of R$14.3b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Transmissora Aliança de Energia Elétrica has a debt to EBITDA ratio of 2.6 and its EBIT covered its interest expense 4.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Unfortunately, Transmissora Aliança de Energia Elétrica saw its EBIT slide 8.9% 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. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Transmissora Aliança de Energia Elétrica's ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. In the last three years, Transmissora Aliança de Energia Elétrica's free cash flow amounted to 47% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

Transmissora Aliança de Energia Elétrica's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. But on the bright side, its ability to to convert EBIT to free cash flow isn't too shabby at all. We should 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 discussed, it seems to us that Transmissora Aliança de Energia Elétrica 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. 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. We've identified 2 warning signs with Transmissora Aliança de Energia Elétrica , and understanding them should be part of your investment process.

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.