Is Essbio (SNSE:ESSBIO-C) Using Too Much Debt?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' 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 Essbio S.A. (SNSE:ESSBIO-C) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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. 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.

Check out our latest analysis for Essbio

How Much Debt Does Essbio Carry?

As you can see below, at the end of June 2020, Essbio had CL$422.2b of debt, up from CL$386.8b a year ago. Click the image for more detail. On the flip side, it has CL$22.9b in cash leading to net debt of about CL$399.3b.

A Look At Essbio's Liabilities

According to the last reported balance sheet, Essbio had liabilities of CL$54.9b due within 12 months, and liabilities of CL$437.0b due beyond 12 months. Offsetting these obligations, it had cash of CL$22.9b as well as receivables valued at CL$36.2b due within 12 months. So it has liabilities totalling CL$432.7b more than its cash and near-term receivables, combined.

When you consider that this deficiency exceeds the company's CL$317.3b market capitalization, you might well be inclined to review the balance sheet intently. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

With a net debt to EBITDA ratio of 5.2, it's fair to say Essbio does have a significant amount of debt. But the good news is that it boasts fairly comforting interest cover of 4.5 times, suggesting it can responsibly service its obligations. Notably Essbio's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. The balance sheet is clearly the area to focus on when you are analysing debt. But it is Essbio'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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Essbio recorded free cash flow worth 59% 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.

Our View

To be frank both Essbio's net debt to EBITDA and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. We should also note that Water Utilities industry companies like Essbio commonly do use debt without problems. Once we consider all the factors above, together, it seems to us that Essbio's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 3 warning signs we've spotted with Essbio (including 2 which is are potentially serious) .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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