Inversiones Aguas Metropolitanas (SNSE:IAM) Takes On Some Risk With Its Use Of Debt

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. As with many other companies Inversiones Aguas Metropolitanas S.A. (SNSE:IAM) makes use of debt. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Inversiones Aguas Metropolitanas

What Is Inversiones Aguas Metropolitanas's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 Inversiones Aguas Metropolitanas had CL$1.19t of debt, an increase on CL$1.09t, over one year. However, it does have CL$148.4b in cash offsetting this, leading to net debt of about CL$1.04t.

How Strong Is Inversiones Aguas Metropolitanas' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Inversiones Aguas Metropolitanas had liabilities of CL$236.9b due within 12 months and liabilities of CL$1.17t due beyond that. Offsetting these obligations, it had cash of CL$148.4b as well as receivables valued at CL$102.6b due within 12 months. So its liabilities total CL$1.16t more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the CL$439.3b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we definitely think shareholders need to watch this one closely. At the end of the day, Inversiones Aguas Metropolitanas would probably need a major re-capitalization if its creditors were to demand repayment.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Inversiones Aguas Metropolitanas has net debt to EBITDA of 3.9 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 7.1 suggests it can easily service that debt. If Inversiones Aguas Metropolitanas can keep growing EBIT at last year's rate of 17% over the last year, then it will find its debt load easier to manage. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Inversiones Aguas Metropolitanas's ability to maintain a healthy balance sheet going forward. 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. In the last three years, Inversiones Aguas Metropolitanas's free cash flow amounted to 36% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We'd go so far as to say Inversiones Aguas Metropolitanas's level of total liabilities was disappointing. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. It's also worth noting that Inversiones Aguas Metropolitanas is in the Water Utilities industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that Inversiones Aguas Metropolitanas'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. However, not all investment risk resides within the balance sheet - far from it. Case in point: We've spotted 4 warning signs for Inversiones Aguas Metropolitanas you should be aware of, and 2 of them can't be ignored.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. We provide commentary based on historical data and analyst forecasts only using an unbiased methodology and our articles are not intended to be financial advice. 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.