Here's Why BKW (VTX:BKW) Has A Meaningful Debt Burden

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says '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 BKW AG (VTX:BKW) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for BKW

What Is BKW's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 BKW had CHF2.64b of debt, an increase on CHF1.54b, over one year. However, it does have CHF951.7m in cash offsetting this, leading to net debt of about CHF1.69b.

How Healthy Is BKW's Balance Sheet?

According to the last reported balance sheet, BKW had liabilities of CHF4.94b due within 12 months, and liabilities of CHF4.79b due beyond 12 months. Offsetting this, it had CHF951.7m in cash and CHF1.76b in receivables that were due within 12 months. So it has liabilities totalling CHF7.02b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CHF6.69b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

BKW's debt is 2.6 times its EBITDA, and its EBIT cover its interest expense 6.1 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. BKW grew its EBIT by 2.4% in the last year. That's far from incredible but it is a good thing, when it comes to paying off debt. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine BKW's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, BKW recorded free cash flow of 24% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Mulling over BKW's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. Having said that, its ability to cover its interest expense with its EBIT isn't such a worry. It's also worth noting that BKW is in the Electric Utilities industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that BKW's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example BKW has 4 warning signs (and 1 which makes us a bit uncomfortable) 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.