Is Naturgy Energy Group (BME:NTGY) Using Too Much 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.' 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, Naturgy Energy Group, S.A. (BME:NTGY) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Naturgy Energy Group

What Is Naturgy Energy Group's Debt?

The chart below, which you can click on for greater detail, shows that Naturgy Energy Group had €15.9b in debt in December 2020; about the same as the year before. However, it does have €4.49b in cash offsetting this, leading to net debt of about €11.4b.

How Healthy Is Naturgy Energy Group's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Naturgy Energy Group had liabilities of €9.25b due within 12 months and liabilities of €19.0b due beyond that. Offsetting this, it had €4.49b in cash and €3.12b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €20.7b.

When you consider that this deficiency exceeds the company's huge €19.7b market capitalization, you might well be inclined to review the balance sheet intently. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Naturgy Energy Group has a debt to EBITDA ratio of 3.8 and its EBIT covered its interest expense 3.0 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Even worse, Naturgy Energy Group saw its EBIT tank 50% over the last 12 months. If earnings keep going like that over the long term, it has a snowball's chance in hell of paying off that debt. 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the most recent three years, Naturgy Energy Group recorded free cash flow worth 77% 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

We'd go so far as to say Naturgy Energy Group's EBIT growth rate was disappointing. But at least it's pretty decent at converting EBIT to free cash flow; that's encouraging. 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. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. Case in point: We've spotted 2 warning signs for Naturgy Energy Group you should be aware of.

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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