Is TransAlta Renewables (TSE:RNW) Using Too Much Debt?

Warren Buffett famously said, '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 can see that TransAlta Renewables Inc. (TSE:RNW) does use debt in its business. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. 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. 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.

Check out our latest analysis for TransAlta Renewables

What Is TransAlta Renewables's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2021 TransAlta Renewables had debt of CA$828.0m, up from CA$794.0m in one year. However, because it has a cash reserve of CA$240.0m, its net debt is less, at about CA$588.0m.

How Healthy Is TransAlta Renewables' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that TransAlta Renewables had liabilities of CA$416.0m due within 12 months and liabilities of CA$1.08b due beyond that. Offsetting these obligations, it had cash of CA$240.0m as well as receivables valued at CA$116.0m due within 12 months. So it has liabilities totalling CA$1.14b more than its cash and near-term receivables, combined.

This deficit isn't so bad because TransAlta Renewables is worth CA$5.10b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.

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.

TransAlta Renewables's net debt to EBITDA ratio of about 2.4 suggests only moderate use of debt. And its strong interest cover of 1k times, makes us even more comfortable. Unfortunately, TransAlta Renewables's EBIT flopped 16% over the last four quarters. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if TransAlta Renewables 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Happily for any shareholders, TransAlta Renewables actually produced more free cash flow than EBIT over the last three years. There's nothing better than incoming cash when it comes to staying in your lenders' good graces.

Our View

Both TransAlta Renewables's ability to to cover its interest expense with its EBIT and its conversion of EBIT to free cash flow gave us comfort that it can handle its debt. But truth be told its EBIT growth rate had us nibbling our nails. When we consider all the elements mentioned above, it seems to us that TransAlta Renewables is managing its debt quite well. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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 instance, we've identified 1 warning sign for TransAlta Renewables that you should be aware of.

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.

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.

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