ENCE Energía y Celulosa (BME:ENC) Seems To Use Debt Quite Sensibly

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. We note that ENCE Energía y Celulosa, S.A. (BME:ENC) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 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 thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for ENCE Energía y Celulosa

What Is ENCE Energía y Celulosa's Debt?

As you can see below, ENCE Energía y Celulosa had €496.3m of debt at March 2022, down from €699.9m a year prior. However, it does have €413.8m in cash offsetting this, leading to net debt of about €82.5m.

How Healthy Is ENCE Energía y Celulosa's Balance Sheet?

The latest balance sheet data shows that ENCE Energía y Celulosa had liabilities of €450.4m due within a year, and liabilities of €536.4m falling due after that. On the other hand, it had cash of €413.8m and €70.4m worth of receivables due within a year. So its liabilities total €502.6m more than the combination of its cash and short-term receivables.

This is a mountain of leverage relative to its market capitalization of €829.8m. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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.

While ENCE Energía y Celulosa's low debt to EBITDA ratio of 0.67 suggests only modest use of debt, the fact that EBIT only covered the interest expense by 3.3 times last year does give us pause. But the interest payments are certainly sufficient to have us thinking about how affordable its debt is. Notably, ENCE Energía y Celulosa made a loss at the EBIT level, last year, but improved that to positive EBIT of €41m in the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if ENCE Energía y Celulosa can strengthen its balance sheet over time. 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 it's worth checking how much of the earnings before interest and tax (EBIT) is backed by free cash flow. Over the last year, ENCE Energía y Celulosa actually produced more free cash flow than EBIT. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

On our analysis ENCE Energía y Celulosa's conversion of EBIT to free cash flow should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For instance it seems like it has to struggle a bit to cover its interest expense with its EBIT. Considering this range of data points, we think ENCE Energía y Celulosa is in a good position to manage its debt levels. But a word of caution: we think debt levels are high enough to justify ongoing monitoring. 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, we've discovered 1 warning sign for ENCE Energía y Celulosa that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.