Stock Analysis

Here's Why Colbún (SNSE:COLBUN) Can Manage Its Debt Responsibly

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David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We can see that Colbún S.A. (SNSE:COLBUN) does use debt in its business. But is this debt a concern to shareholders?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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 think about a company's use of debt, we first look at cash and debt together.

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How Much Debt Does Colbún Carry?

As you can see below, Colbún had US$2.02b of debt at December 2022, down from US$2.22b a year prior. On the flip side, it has US$1.13b in cash leading to net debt of about US$886.7m.

SNSE:COLBUN Debt to Equity History March 18th 2023

How Strong Is Colbún's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Colbún had liabilities of US$542.7m due within 12 months and liabilities of US$3.11b due beyond that. Offsetting this, it had US$1.13b in cash and US$421.3m in receivables that were due within 12 months. So its liabilities total US$2.10b more than the combination of its cash and short-term receivables.

When you consider that this deficiency exceeds the company's US$1.97b 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Colbún's net debt is only 1.3 times its EBITDA. And its EBIT covers its interest expense a whopping 12.5 times over. So we're pretty relaxed about its super-conservative use of debt. Better yet, Colbún grew its EBIT by 120% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Colbún can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the most recent three years, Colbún recorded free cash flow worth 65% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Colbún's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its level of total liabilities has the opposite effect. Looking at all the aforementioned factors together, it strikes us that Colbún can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. 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 Colbún has 3 warning signs (and 2 which are a bit concerning) we think you should know about.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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