These 4 Measures Indicate That Enagás (BME:ENG) Is Using Debt Extensively

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.' 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. Importantly, Enagás, S.A. (BME:ENG) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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. 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.

View our latest analysis for Enagás

What Is Enagás's Net Debt?

As you can see below, Enagás had €4.84b of debt at June 2022, down from €5.13b a year prior. However, because it has a cash reserve of €826.6m, its net debt is less, at about €4.01b.

How Healthy Is Enagás' Balance Sheet?

We can see from the most recent balance sheet that Enagás had liabilities of €1.57b falling due within a year, and liabilities of €4.53b due beyond that. Offsetting this, it had €826.6m in cash and €274.1m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €5.00b.

Given this deficit is actually higher than the company's market capitalization of €4.51b, we think shareholders really should watch Enagás's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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).

With a net debt to EBITDA ratio of 7.1, it's fair to say Enagás does have a significant amount of debt. However, its interest coverage of 5.4 is reasonably strong, which is a good sign. Unfortunately, Enagás's EBIT flopped 16% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Enagás can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Enagás actually produced more free cash flow than EBIT. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

On the face of it, Enagás's EBIT growth rate left us tentative about the stock, and its net debt to EBITDA was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. It's also worth noting that Enagás is in the Gas Utilities industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that Enagás's debt is making it a bit risky. That's not necessarily a bad thing, but we'd generally feel more comfortable with less leverage. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. To that end, you should learn about the 5 warning signs we've spotted with Enagás (including 3 which shouldn't be ignored) .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.