We Think Transmissora Aliança de Energia Elétrica (BVMF:TAEE11) Can Stay On Top Of Its Debt

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 should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Transmissora Aliança de Energia Elétrica

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 2020 Transmissora Aliança de Energia Elétrica had debt of R$6.62b, up from R$4.74b in one year. However, it does have R$1.79b in cash offsetting this, leading to net debt of about R$4.83b.

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

According to the last reported balance sheet, Transmissora Aliança de Energia Elétrica had liabilities of R$926.1m due within 12 months, and liabilities of R$7.17b due beyond 12 months. Offsetting these obligations, it had cash of R$1.79b as well as receivables valued at R$1.45b due within 12 months. So its liabilities total R$4.85b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since Transmissora Aliança de Energia Elétrica has a market capitalization of R$11.3b, and so it could probably strengthen its balance sheet by raising capital if it needed to. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Transmissora Aliança de Energia Elétrica has a debt to EBITDA ratio of 2.8 and its EBIT covered its interest expense 7.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Importantly, Transmissora Aliança de Energia Elétrica grew its EBIT by 45% over the last twelve months, and that growth will make it easier to handle 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Transmissora Aliança de Energia Elétrica recorded free cash flow worth 67% 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

Happily, Transmissora Aliança de Energia Elétrica's impressive EBIT growth rate implies it has the upper hand on its debt. But truth be told we feel its net debt to EBITDA does undermine this impression a bit. We would also note that Electric Utilities industry companies like Transmissora Aliança de Energia Elétrica commonly do use debt without problems. Taking all this data into account, it seems to us that Transmissora Aliança de Energia Elétrica takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. 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. Case in point: We've spotted 3 warning signs for Transmissora Aliança de Energia Elétrica you should be aware of, and 2 of them can't be ignored.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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