Here's Why CEZ a. s (SEP:CEZ) Has A Meaningful Debt Burden

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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 should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. 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.

Check out our latest analysis for CEZ a. s

What Is CEZ a. s's Debt?

As you can see below, CEZ a. s had Kč141.2b of debt at September 2021, down from Kč169.7b a year prior. However, because it has a cash reserve of Kč11.5b, its net debt is less, at about Kč129.8b.

A Look At CEZ a. s' Liabilities

The latest balance sheet data shows that CEZ a. s had liabilities of Kč795.4b due within a year, and liabilities of Kč250.3b falling due after that. Offsetting this, it had Kč11.5b in cash and Kč84.5b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by Kč949.7b.

The deficiency here weighs heavily on the Kč432.1b 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'd watch its balance sheet closely, without a doubt. After all, CEZ a. s would likely require a major re-capitalisation if it had to pay its creditors today.

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

With a debt to EBITDA ratio of 2.0, CEZ a. s uses debt artfully but responsibly. And the fact that its trailing twelve months of EBIT was 7.2 times its interest expenses harmonizes with that theme. Sadly, CEZ a. s's EBIT actually dropped 9.2% in the last year. If earnings continue on that decline then managing that debt will be difficult like delivering hot soup on a unicycle. 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're focused on the future you can check out this free report showing analyst profit forecasts.

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. In the last three years, CEZ a. s's free cash flow amounted to 49% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Mulling over CEZ a. s's attempt at staying on top of its total liabilities, we're certainly not enthusiastic. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. We should also note that Electric Utilities industry companies like CEZ a. s commonly do use debt without problems. Looking at the bigger picture, it seems clear to us that CEZ a. s's use of debt is creating risks for the company. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the debt. 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. For example CEZ a. s has 2 warning signs (and 1 which is a bit unpleasant) we think you should know about.

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.