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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. Importantly, Iberdrola, S.A. (BME:IBE) does carry debt. But the real question is whether this debt is making the company risky.
When Is Debt A Problem?
Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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, 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. The first step when considering a company's debt levels is to consider its cash and debt together.
How Much Debt Does Iberdrola Carry?
The image below, which you can click on for greater detail, shows that at September 2020 Iberdrola had debt of €39.8b, up from €38.1b in one year. On the flip side, it has €2.67b in cash leading to net debt of about €37.1b.
A Look At Iberdrola's Liabilities
The latest balance sheet data shows that Iberdrola had liabilities of €19.5b due within a year, and liabilities of €56.7b falling due after that. On the other hand, it had cash of €2.67b and €7.62b worth of receivables due within a year. So its liabilities total €65.8b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its very significant market capitalization of €68.9b, so it does suggest shareholders should keep an eye on Iberdrola's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
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).
Iberdrola's debt is 4.0 times its EBITDA, and its EBIT cover its interest expense 6.5 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Unfortunately, Iberdrola saw its EBIT slide 9.3% in the last twelve months. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Iberdrola 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, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So we always check how much of that EBIT is translated into free cash flow. In the last three years, Iberdrola's free cash flow amounted to 39% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
To be frank both Iberdrola's level of total liabilities and its track record of managing its debt, based on its EBITDA, make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. It's also worth noting that Iberdrola is in the Electric Utilities industry, which is often considered to be quite defensive. Once we consider all the factors above, together, it seems to us that Iberdrola's debt is making it a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less 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 - Iberdrola has 2 warning signs we think you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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