These 4 Measures Indicate That Hydro One (TSE:H) Is Using Debt Extensively

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.' 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 Hydro One Limited (TSE:H) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

See 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$14.5b in debt in September 2022; about the same as the year before. Net debt is about the same, since the it doesn't have much cash.

A Look At Hydro One's Liabilities

According to the last reported balance sheet, Hydro One had liabilities of CA$3.47b due within 12 months, and liabilities of CA$16.0b due beyond 12 months. Offsetting these obligations, it had cash of CA$25.0m as well as receivables valued at CA$1.02b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$18.5b.

This is a mountain of leverage even relative to its gargantuan market capitalization of CA$20.9b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

With a net debt to EBITDA ratio of 5.4, it's fair to say Hydro One does have a significant amount of debt. However, its interest coverage of 4.0 is reasonably strong, which is a good sign. The good news is that Hydro One improved its EBIT by 5.8% over the last twelve months, thus gradually reducing its debt levels relative to its earnings. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Hydro One can strengthen its balance sheet over time. 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. Over the last three years, Hydro One reported free cash flow worth 7.6% 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

We'd go so far as to say Hydro One's net debt to EBITDA was disappointing. Having said that, its ability to grow its EBIT isn't such a worry. 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. However, not all investment risk resides within the balance sheet - far from it. For example Hydro One has 2 warning signs (and 1 which doesn't sit too well with us) we think you should know about.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.