Here's Why CEZ a. s (SEP:CEZ) Can Manage Its Debt Responsibly

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.' 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 CEZ, a. s. (SEP:CEZ) makes use of debt. But the more important question is: how much risk is that debt creating?

What Risk Does Debt Bring?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for CEZ a. s

What Is CEZ a. s's Debt?

The image below, which you can click on for greater detail, shows that CEZ a. s had debt of Kč154.8b at the end of September 2023, a reduction from Kč205.9b over a year. However, it also had Kč18.5b in cash, and so its net debt is Kč136.3b.

How Strong Is CEZ a. s' Balance Sheet?

Zooming in on the latest balance sheet data, we can see that CEZ a. s had liabilities of Kč216.7b due within 12 months and liabilities of Kč337.7b due beyond that. On the other hand, it had cash of Kč18.5b and Kč103.9b worth of receivables due within a year. So it has liabilities totalling Kč431.9b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of Kč445.8b, so it does suggest shareholders should keep an eye on CEZ a. s' use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). 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).

CEZ a. s has a low net debt to EBITDA ratio of only 0.98. And its EBIT covers its interest expense a whopping 16.5 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that CEZ a. s has boosted its EBIT by 46%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine CEZ a. s'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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, CEZ a. s recorded free cash flow worth 54% 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

Happily, CEZ a. s's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its level of total liabilities has the opposite effect. It's also worth noting that CEZ a. s is in the Electric Utilities industry, which is often considered to be quite defensive. All these things considered, it appears that CEZ a. s can comfortably handle its current debt levels. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. 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. We've identified 3 warning signs with CEZ a. s (at least 1 which is a bit unpleasant) , and understanding them should be part of your investment process.

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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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.