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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Transmissora Aliança de Energia Elétrica S.A. (BVMF:TAEE11) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt Dangerous?

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. If things get really bad, the lenders can take control of the business. 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Transmissora Aliança de Energia Elétrica

What Is Transmissora Aliança de Energia Elétrica's Debt?

The image below, which you can click on for greater detail, shows that at September 2022 Transmissora Aliança de Energia Elétrica had debt of R$8.50b, up from R$7.00b in one year. On the flip side, it has R$1.56b in cash leading to net debt of about R$6.94b.

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

The latest balance sheet data shows that Transmissora Aliança de Energia Elétrica had liabilities of R$975.3m due within a year, and liabilities of R$9.93b falling due after that. On the other hand, it had cash of R$1.56b and R$1.82b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by R$7.51b.

Transmissora Aliança de Energia Elétrica has a market capitalization of R$12.8b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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). 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 a debt to EBITDA ratio of 3.1 and its EBIT covered its interest expense 4.8 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Importantly, Transmissora Aliança de Energia Elétrica's EBIT fell a jaw-dropping 25% in the last twelve months. If that decline continues then paying off debt will be harder than selling foie gras at a vegan convention. There's no doubt that we learn most about debt from the balance sheet. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. Over the most recent three years, Transmissora Aliança de Energia Elétrica recorded free cash flow worth 50% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

We'd go so far as to say Transmissora Aliança de Energia Elétrica's EBIT growth rate was disappointing. But at least its conversion of EBIT to free cash flow is not so bad. 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. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Transmissora Aliança de Energia Elétrica stock a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. 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. Be aware that Transmissora Aliança de Energia Elétrica is showing 2 warning signs in our investment analysis , you should know about...

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.