Is Empresa Eléctrica de Magallanes (SNSE:EDELMAG) A Risky Investment?

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Empresa Eléctrica de Magallanes S.A. (SNSE:EDELMAG) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

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. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

Check out 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 March 2021, Empresa Eléctrica de Magallanes had CL$9.87b of debt, up from CL$8.39b a year ago. Click the image for more detail. However, it also had CL$2.01b in cash, and so its net debt is CL$7.86b.

How Strong Is Empresa Eléctrica de Magallanes' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Empresa Eléctrica de Magallanes had liabilities of CL$10.7b due within 12 months and liabilities of CL$19.8b due beyond that. Offsetting these obligations, it had cash of CL$2.01b as well as receivables valued at CL$7.73b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by CL$20.8b.

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 0.53 times its EBITDA. And its EBIT covers its interest expense a whopping 36.2 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Empresa Eléctrica de Magallanes's EBIT was pretty flat over the last year, but that shouldn't be an issue given the it doesn't have a lot of debt. There's no doubt that we learn most about debt from the balance sheet. But it is Empresa Eléctrica de Magallanes's earnings that will influence how the balance sheet holds up in the future. So if you're keen to discover more about its earnings, it might be worth checking out this graph of its long term earnings trend.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. During the last three years, Empresa Eléctrica de Magallanes produced sturdy free cash flow equating to 58% 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 the good news does not stop there, as its net debt to EBITDA also supports that impression! We would also note that Electric Utilities industry companies like Empresa Eléctrica de Magallanes commonly do use debt without problems. When we consider the range of factors above, it looks like Empresa Eléctrica de Magallanes is pretty sensible with its use of debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should be aware of the 1 warning sign we've spotted with Empresa Eléctrica de Magallanes .

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.

If you’re looking to trade Empresa Eléctrica de Magallanes, open an account with the lowest-cost* platform trusted by professionals, Interactive Brokers. Their clients from over 200 countries and territories trade stocks, options, futures, forex, bonds and funds worldwide from a single integrated account. Promoted

This article by Simply Wall St is general in nature. 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.
^*Interactive Brokers Rated Lowest Cost Broker by StockBrokers.com Annual Online Review 2020

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.