Is Canadian Utilities (TSE:CU) A Risky Investment?

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. We note that Canadian Utilities Limited (TSE:CU) does have debt on its balance sheet. 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. 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 Canadian Utilities

What Is Canadian Utilities's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Canadian Utilities had CA$10.7b of debt, an increase on CA$10.2b, over one year. However, it does have CA$380.0m in cash offsetting this, leading to net debt of about CA$10.3b.

How Strong Is Canadian Utilities' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Canadian Utilities had liabilities of CA$1.04b due within 12 months and liabilities of CA$15.0b due beyond that. On the other hand, it had cash of CA$380.0m and CA$503.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$15.2b.

This deficit casts a shadow over the CA$9.66b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Canadian Utilities would likely require a major re-capitalisation if it had to pay its creditors today.

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).

Weak interest cover of 2.3 times and a disturbingly high net debt to EBITDA ratio of 6.0 hit our confidence in Canadian Utilities like a one-two punch to the gut. This means we'd consider it to have a heavy debt load. Worse, Canadian Utilities's EBIT was down 23% over the last year. 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 Canadian Utilities'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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. During the last three years, Canadian Utilities produced sturdy free cash flow equating to 53% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

To be frank both Canadian Utilities's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We should also note that Integrated Utilities industry companies like Canadian Utilities commonly do use debt without problems. Taking into account all the aforementioned factors, it looks like Canadian Utilities has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. Be aware that Canadian Utilities is showing 3 warning signs in our investment analysis , you should know about...

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.