Innergex Renewable Energy (TSE:INE) Takes On Some Risk With Its Use Of Debt

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.' 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. Importantly, Innergex Renewable Energy Inc. (TSE:INE) does carry debt. But the real question is whether this debt is making the company risky.

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. 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 step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Innergex Renewable Energy

What Is Innergex Renewable Energy's Net Debt?

As you can see below, Innergex Renewable Energy had CA$4.30b of debt at June 2020, down from CA$4.67b a year prior. On the flip side, it has CA$229.0m in cash leading to net debt of about CA$4.07b.

How Healthy Is Innergex Renewable Energy's Balance Sheet?

We can see from the most recent balance sheet that Innergex Renewable Energy had liabilities of CA$723.6m falling due within a year, and liabilities of CA$4.94b due beyond that. Offsetting this, it had CA$229.0m in cash and CA$165.3m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CA$5.27b.

When you consider that this deficiency exceeds the company's CA$4.52b market capitalization, you might well be inclined to review the balance sheet intently. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive 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). 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).

Weak interest cover of 1.3 times and a disturbingly high net debt to EBITDA ratio of 8.1 hit our confidence in Innergex Renewable Energy like a one-two punch to the gut. The debt burden here is substantial. Looking on the bright side, Innergex Renewable Energy boosted its EBIT by a silky 38% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing 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 Innergex Renewable Energy 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So it's worth checking how much of that EBIT is backed by free cash flow. Over the last three years, Innergex Renewable Energy saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

To be frank both Innergex Renewable Energy's interest cover and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We're quite clear that we consider Innergex Renewable Energy to be really rather risky, as a result of its balance sheet health. For this reason we're pretty cautious about the stock, and we think shareholders should keep a close eye on its liquidity. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. Take risks, for example - Innergex Renewable Energy has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

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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