Here's Why Hydro One (TSE:H) Has A Meaningful Debt Burden

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' 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. Importantly, Hydro One Limited (TSE:H) does carry 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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Hydro One

What Is Hydro One's Debt?

The chart below, which you can click on for greater detail, shows that Hydro One had CA$13.9b in debt in March 2021; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.

A Look At Hydro One's Liabilities

Zooming in on the latest balance sheet data, we can see that Hydro One had liabilities of CA$2.98b due within 12 months and liabilities of CA$16.3b due beyond that. On the other hand, it had cash of CA$121.0m and CA$1.02b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$18.2b.

This is a mountain of leverage even relative to its gargantuan market capitalization of CA$18.3b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Hydro One has a rather high debt to EBITDA ratio of 5.9 which suggests a meaningful debt load. But the good news is that it boasts fairly comforting interest cover of 3.4 times, suggesting it can responsibly service its obligations. However, one redeeming factor is that Hydro One grew its EBIT at 14% over the last 12 months, boosting its ability to handle its debt. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Hydro One 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Hydro One reported free cash flow worth 3.1% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Mulling over Hydro One's attempt at managing its debt, based on its EBITDA,, we're certainly not enthusiastic. But at least it's pretty decent at growing its EBIT; that's encouraging. It's also worth noting that Hydro One is in the Electric Utilities industry, which is often considered to be quite defensive. Overall, we think it's fair to say that Hydro One has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. We've identified 3 warning signs with Hydro One (at least 2 which are potentially serious) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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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