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 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. Importantly, Enel Generación Chile S.A. (SNSE:ENELGXCH) does carry debt. But should shareholders be worried about its use of debt?
What Risk Does Debt Bring?
Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Enel Generación Chile's Debt?
The chart below, which you can click on for greater detail, shows that Enel Generación Chile had CL$864.2b in debt in September 2020; about the same as the year before. And it doesn't have much cash, so its net debt is about the same.
A Look At Enel Generación Chile's Liabilities
Zooming in on the latest balance sheet data, we can see that Enel Generación Chile had liabilities of CL$344.8b due within 12 months and liabilities of CL$1.10t due beyond that. Offsetting these obligations, it had cash of CL$5.53b as well as receivables valued at CL$284.9b due within 12 months. So it has liabilities totalling CL$1.16t more than its cash and near-term receivables, combined.
This deficit isn't so bad because Enel Generación Chile is worth CL$2.23t, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.
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.
We'd say that Enel Generación Chile's moderate net debt to EBITDA ratio ( being 1.7), indicates prudence when it comes to debt. And its strong interest cover of 11.0 times, makes us even more comfortable. The bad news is that Enel Generación Chile saw its EBIT decline by 20% over the last year. If that sort of decline is not arrested, then the managing its debt will be harder than selling broccoli flavoured ice-cream for a premium. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Enel Generación Chile can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.
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. Over the most recent three years, Enel Generación Chile recorded free cash flow worth 64% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This cold hard cash means it can reduce its debt when it wants to.
Enel Generación Chile's EBIT growth rate was a real negative on this analysis, although the other factors we considered cast it in a significantly better light. In particular, its interest cover was re-invigorating. We think that Enel Generación Chile's debt does make it a bit risky, after considering the aforementioned data points together. That's not necessarily a bad thing, since leverage can boost returns on equity, but it is something to be aware of. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 2 warning signs for Enel Generación Chile you should be aware of, and 1 of them doesn't sit too well with us.
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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