Compañía General de Electricidad (SNSE:CGE) 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.' 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. As with many other companies Compañía General de Electricidad S.A. (SNSE:CGE) makes use of debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. 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. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for Compañía General de Electricidad

What Is Compañía General de Electricidad's Debt?

As you can see below, at the end of December 2020, Compañía General de Electricidad had CL$1.51t of debt, up from CL$1.24t a year ago. Click the image for more detail. However, it does have CL$325.6b in cash offsetting this, leading to net debt of about CL$1.19t.

How Strong Is Compañía General de Electricidad's Balance Sheet?

We can see from the most recent balance sheet that Compañía General de Electricidad had liabilities of CL$483.1b falling due within a year, and liabilities of CL$1.86t due beyond that. Offsetting these obligations, it had cash of CL$325.6b as well as receivables valued at CL$373.8b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CL$1.65t.

This is a mountain of leverage relative to its market capitalization of CL$2.21t. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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).

With a net debt to EBITDA ratio of 5.4, it's fair to say Compañía General de Electricidad does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 4.3 times, suggesting it can responsibly service its obligations. Worse, Compañía General de Electricidad's EBIT was down 24% over the last year. If earnings continue to follow that trajectory, paying off that debt load will be harder than convincing us to run a marathon in the rain. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Compañía General de Electricidad will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Compañía General de Electricidad produced sturdy free cash flow equating to 55% of its EBIT, about what we'd expect. This cold hard cash means it can reduce its debt when it wants to.

Our View

To be frank both Compañía General de Electricidad's net debt to EBITDA and its track record of (not) growing its EBIT make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. It's also worth noting that Compañía General de Electricidad is in the Electric Utilities industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that Compañía General de Electricidad's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. For example, we've discovered 3 warning signs for Compañía General de Electricidad (1 is concerning!) that you should be aware of before investing here.

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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