We Think EnBW Energie Baden-Württemberg (ETR:EBK) Is Taking Some Risk With Its Debt

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, EnBW Energie Baden-Württemberg AG (ETR:EBK) does carry debt. But should shareholders be worried about its use of debt?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for EnBW Energie Baden-Württemberg

What Is EnBW Energie Baden-Württemberg's Net Debt?

The image below, which you can click on for greater detail, shows that at June 2023 EnBW Energie Baden-Württemberg had debt of €14.8b, up from €10.4b in one year. However, because it has a cash reserve of €6.46b, its net debt is less, at about €8.30b.

A Look At EnBW Energie Baden-Württemberg's Liabilities

The latest balance sheet data shows that EnBW Energie Baden-Württemberg had liabilities of €19.8b due within a year, and liabilities of €30.0b falling due after that. On the other hand, it had cash of €6.46b and €5.93b worth of receivables due within a year. So its liabilities total €37.4b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the €22.2b 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, EnBW Energie Baden-Württemberg 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.

EnBW Energie Baden-Württemberg's net debt is only 1.2 times its EBITDA. And its EBIT easily covers its interest expense, being 27.9 times the size. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that EnBW Energie Baden-Württemberg grew its EBIT by 272% over twelve months. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But you can't view debt in total isolation; since EnBW Energie Baden-Württemberg will need earnings to service that debt. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Looking at the most recent three years, EnBW Energie Baden-Württemberg recorded free cash flow of 33% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

We feel some trepidation about EnBW Energie Baden-Württemberg's difficulty level of total liabilities, but we've got positives to focus on, too. For example, its interest cover and EBIT growth rate give us some confidence in its ability to manage its debt. It's also worth noting that EnBW Energie Baden-Württemberg is in the Electric Utilities industry, which is often considered to be quite defensive. We think that EnBW Energie Baden-Württemberg's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. Be aware that EnBW Energie Baden-Württemberg is showing 2 warning signs in our investment analysis , 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.