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

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. Importantly, Transmissora Aliança de Energia Elétrica S.A. (BVMF:TAEE11) does carry debt. But the more important question is: how much risk is that debt creating?

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 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.

View 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 March 2023 Transmissora Aliança de Energia Elétrica had R$9.40b of debt, an increase on R$7.71b, over one year. However, it does have R$1.04b in cash offsetting this, leading to net debt of about R$8.37b.

How Healthy 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$1.13b due within a year, and liabilities of R$10.8b falling due after that. Offsetting these obligations, it had cash of R$1.04b as well as receivables valued at R$1.90b due within 12 months. So its liabilities total R$9.00b more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of R$12.8b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). 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 4.8 and its EBIT covered its interest expense 3.6 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Worse, Transmissora Aliança de Energia Elétrica's EBIT was down 35% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. 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 45% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

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. Overall, we think it's fair to say that Transmissora Aliança de Energia Elétrica has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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 instance, we've identified 2 warning signs for Transmissora Aliança de Energia Elétrica that you should be aware of.

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.