Does Naturgy Energy Group (BME:NTGY) Have A Healthy Balance Sheet?

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We note that Naturgy Energy Group, S.A. (BME:NTGY) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. 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.

See our latest analysis for Naturgy Energy Group

What Is Naturgy Energy Group's Net Debt?

As you can see below, Naturgy Energy Group had €16.1b of debt at March 2021, down from €17.9b a year prior. However, because it has a cash reserve of €4.38b, its net debt is less, at about €11.7b.

How Healthy Is Naturgy Energy Group's Balance Sheet?

The latest balance sheet data shows that Naturgy Energy Group had liabilities of €9.10b due within a year, and liabilities of €19.4b falling due after that. Offsetting these obligations, it had cash of €4.38b as well as receivables valued at €3.25b due within 12 months. So it has liabilities totalling €20.9b more than its cash and near-term receivables, combined.

Given this deficit is actually higher than the company's massive market capitalization of €20.7b, we think shareholders really should watch Naturgy Energy Group's debt levels, like a parent watching their child ride a bike for the first time. In the scenario where the company had to clean up its balance sheet quickly, it seems likely shareholders would suffer extensive dilution.

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). 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).

Naturgy Energy Group has a debt to EBITDA ratio of 3.5 and its EBIT covered its interest expense 4.3 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. Another concern for investors might be that Naturgy Energy Group's EBIT fell 18% in the last year. If that's the way things keep going handling the debt load will be like delivering hot coffees on a pogo stick. 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 Naturgy Energy Group 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 the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the most recent three years, Naturgy Energy Group recorded free cash flow worth 73% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Mulling over Naturgy Energy Group's attempt at (not) growing its EBIT, we're certainly not enthusiastic. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We should also note that Gas Utilities industry companies like Naturgy Energy Group commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Naturgy Energy Group stock 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. However, not all investment risk resides within the balance sheet - far from it. To that end, you should be aware of the 2 warning signs we've spotted with Naturgy Energy Group .

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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This article by Simply Wall St is general in nature. 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.
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