These 4 Measures Indicate That Canadian Utilities (TSE:CU) Is Using Debt In A Risky Way

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We can see that Canadian Utilities Limited (TSE:CU) does use debt in its business. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Canadian Utilities

What Is Canadian Utilities's Net Debt?

The chart below, which you can click on for greater detail, shows that Canadian Utilities had CA$9.08b in debt in December 2020; about the same as the year before. However, it does have CA$781.0m in cash offsetting this, leading to net debt of about CA$8.30b.

How Strong Is Canadian Utilities' Balance Sheet?

We can see from the most recent balance sheet that Canadian Utilities had liabilities of CA$856.0m falling due within a year, and liabilities of CA$12.6b due beyond that. Offsetting these obligations, it had cash of CA$781.0m as well as receivables valued at CA$690.0m due within 12 months. So its liabilities total CA$12.0b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's market capitalization of CA$9.39b, we think shareholders really should watch Canadian Utilities's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its 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).

Canadian Utilities has a rather high debt to EBITDA ratio of 5.4 which suggests a meaningful debt load. However, its interest coverage of 2.6 is reasonably strong, which is a good sign. Worse, Canadian Utilities's EBIT was down 21% 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 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Looking at the most recent three years, Canadian Utilities recorded free cash flow of 21% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

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. And even its interest cover fails to inspire much confidence. We should also note that Integrated Utilities industry companies like Canadian Utilities commonly do use debt without problems. After considering the datapoints discussed, we think Canadian Utilities has too much debt. That sort of riskiness is ok for some, but it certainly doesn't float our boat. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 4 warning signs with Canadian Utilities (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

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. 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.
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