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

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We can see that Hydro One Limited (TSE:H) does use debt in its business. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. 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.

See our latest analysis for Hydro One

How Much Debt Does Hydro One Carry?

You can click the graphic below for the historical numbers, but it shows that as of March 2023 Hydro One had CA$15.0b of debt, an increase on CA$14.4b, over one year. Net debt is about the same, since the it doesn't have much cash.

A Look At Hydro One's Liabilities

We can see from the most recent balance sheet that Hydro One had liabilities of CA$2.33b falling due within a year, and liabilities of CA$17.6b due beyond that. Offsetting these obligations, it had cash of CA$43.0m as well as receivables valued at CA$1.09b due within 12 months. So its liabilities total CA$18.8b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its very significant market capitalization of CA$23.1b, so it does suggest shareholders should keep an eye on Hydro One's use of debt. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Hydro One has a rather high debt to EBITDA ratio of 5.7 which suggests a meaningful debt load. However, its interest coverage of 3.7 is reasonably strong, which is a good sign. Fortunately, Hydro One grew its EBIT by 5.9% in the last year, slowly shrinking its debt relative to earnings. There's no doubt that we learn most about debt from the balance sheet. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, Hydro One barely recorded positive free cash flow, in total. While many companies do operate at break-even, we prefer see substantial free cash flow, especially if a it already has dead.

Our View

Mulling over Hydro One's attempt at managing its debt, based on its EBITDA,, we're certainly not enthusiastic. But at least its EBIT growth rate is not so bad. 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 everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. Case in point: We've spotted 2 warning signs for Hydro One you should be aware of, and 1 of them is potentially serious.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.