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

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 the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we think about a company's use of debt, we first look at cash and debt together.

Check out 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 June 2023 Transmissora Aliança de Energia Elétrica had debt of R$9.54b, up from R$8.67b in one year. On the flip side, it has R$1.32b in cash leading to net debt of about R$8.22b.

How Strong 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$1.19b due within 12 months and liabilities of R$10.9b due beyond that. Offsetting these obligations, it had cash of R$1.32b as well as receivables valued at R$2.00b due within 12 months. So it has liabilities totalling R$8.79b more than its cash and near-term receivables, combined.

This is a mountain of leverage relative to its market capitalization of R$12.0b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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.

With a net debt to EBITDA ratio of 5.7, it's fair to say Transmissora Aliança de Energia Elétrica does have a significant amount of debt. However, its interest coverage of 2.7 is reasonably strong, which is a good sign. Even worse, Transmissora Aliança de Energia Elétrica saw its EBIT tank 46% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. The balance sheet is clearly the area to focus on when you are analysing debt. 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're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Transmissora Aliança de Energia Elétrica recorded free cash flow worth 52% 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

On the face of it, Transmissora Aliança de Energia Elétrica's net debt to EBITDA left us tentative about the stock, and its EBIT growth rate was no more enticing than the one empty restaurant on the busiest night of the year. But at least its conversion of EBIT to free cash flow is not so bad. We should also note that Electric Utilities industry companies like Transmissora Aliança de Energia Elétrica commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that Transmissora Aliança de Energia Elétrica's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Transmissora Aliança de Energia Elétrica (including 2 which are a bit concerning) .

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.