We Think Canadian Utilities (TSE:CU) Is Taking Some Risk With Its Debt

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.' 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. We note that Canadian Utilities Limited (TSE:CU) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

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. 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. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Canadian Utilities

What Is Canadian Utilities's Net Debt?

As you can see below, Canadian Utilities had CA$9.54b of debt, at December 2022, which is about the same as the year before. You can click the chart for greater detail. However, it also had CA$698.0m in cash, and so its net debt is CA$8.85b.

How Healthy Is Canadian Utilities' Balance Sheet?

We can see from the most recent balance sheet that Canadian Utilities had liabilities of CA$1.32b falling due within a year, and liabilities of CA$13.6b due beyond that. Offsetting these obligations, it had cash of CA$698.0m as well as receivables valued at CA$913.0m due within 12 months. So its liabilities total CA$13.3b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's CA$9.78b market capitalization, you might well be inclined to review the balance sheet intently. 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.

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.

Canadian Utilities's debt is 5.0 times its EBITDA, and its EBIT cover its interest expense 3.1 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. On a lighter note, we note that Canadian Utilities grew its EBIT by 28% in the last year. If sustained, this growth should make that debt evaporate like a scarce drinking water during an unnaturally hot summer. 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 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. During the last three years, Canadian Utilities produced sturdy free cash flow equating to 66% 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

Neither Canadian Utilities's ability to handle its total liabilities nor its net debt to EBITDA gave us confidence in its ability to take on more debt. But its EBIT growth rate tells a very different story, and suggests some resilience. It's also worth noting that Canadian Utilities is in the Integrated Utilities industry, which is often considered to be quite defensive. Looking at all the angles mentioned above, it does seem to us that Canadian Utilities is a somewhat risky investment as a result of its debt. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. 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 be aware of the 1 warning sign we've spotted with Canadian Utilities .

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.