Empresa Eléctrica de Magallanes (SNSE:EDELMAG) Seems To Use Debt Rather Sparingly

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.' 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 note that Empresa Eléctrica de Magallanes S.A. (SNSE:EDELMAG) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. 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. 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.

See our latest analysis for Empresa Eléctrica de Magallanes

What Is Empresa Eléctrica de Magallanes's Net Debt?

As you can see below, at the end of September 2020, Empresa Eléctrica de Magallanes had CL$9.90b of debt, up from CL$8.40b a year ago. Click the image for more detail. However, it does have CL$5.33b in cash offsetting this, leading to net debt of about CL$4.57b.

How Strong Is Empresa Eléctrica de Magallanes' Balance Sheet?

We can see from the most recent balance sheet that Empresa Eléctrica de Magallanes had liabilities of CL$14.2b falling due within a year, and liabilities of CL$17.7b due beyond that. Offsetting this, it had CL$5.33b in cash and CL$10.6b in receivables that were due within 12 months. So it has liabilities totalling CL$16.0b more than its cash and near-term receivables, combined.

This deficit isn't so bad because Empresa Eléctrica de Magallanes is worth CL$79.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Empresa Eléctrica de Magallanes's net debt is only 0.29 times its EBITDA. And its EBIT easily covers its interest expense, being 105 times the size. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Also positive, Empresa Eléctrica de Magallanes grew its EBIT by 27% in the last year, and that should make it easier to pay down debt, going forward. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since Empresa Eléctrica de Magallanes 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, 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. During the last three years, Empresa Eléctrica de Magallanes produced sturdy free cash flow equating to 67% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Happily, Empresa Eléctrica de Magallanes's impressive interest cover implies it has the upper hand on its debt. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. We would also note that Electric Utilities industry companies like Empresa Eléctrica de Magallanes commonly do use debt without problems. Overall, we don't think Empresa Eléctrica de Magallanes is taking any bad risks, as its debt load seems modest. So the balance sheet looks pretty healthy, to us. 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. Take risks, for example - Empresa Eléctrica de Magallanes has 1 warning sign we think 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.

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