Is Naturgy Energy Group (BME:NTGY) Using Too Much Debt?

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, Naturgy Energy Group, S.A. (BME:NTGY) does carry debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we think about a company's use of debt, we first look at cash and debt together.

Check out our latest analysis for Naturgy Energy Group

What Is Naturgy Energy Group's Net Debt?

The chart below, which you can click on for greater detail, shows that Naturgy Energy Group had €14.7b in debt in June 2024; about the same as the year before. However, because it has a cash reserve of €4.33b, its net debt is less, at about €10.3b.

How Healthy Is Naturgy Energy Group's Balance Sheet?

According to the last reported balance sheet, Naturgy Energy Group had liabilities of €6.74b due within 12 months, and liabilities of €19.2b due beyond 12 months. Offsetting these obligations, it had cash of €4.33b as well as receivables valued at €3.00b due within 12 months. So it has liabilities totalling €18.6b more than its cash and near-term receivables, combined.

This is a mountain of leverage even relative to its gargantuan market capitalization of €21.9b. 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Naturgy Energy Group's net debt of 2.0 times EBITDA suggests graceful use of debt. And the alluring interest cover (EBIT of 7.7 times interest expense) certainly does not do anything to dispel this impression. Sadly, Naturgy Energy Group's EBIT actually dropped 6.9% in the last year. If that earnings trend continues then its debt load will grow heavy like the heart of a polar bear watching its sole cub. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Naturgy Energy Group's ability to maintain a healthy balance sheet going forward. 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 company can only pay off debt with cold hard cash, not accounting profits. So it's worth checking how much of that EBIT is backed by free cash flow. Looking at the most recent three years, Naturgy Energy Group recorded free cash flow of 47% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

While Naturgy Energy Group's EBIT growth rate makes us cautious about it, its track record of staying on top of its total liabilities is no better. At least its interest cover gives us reason to be optimistic. We should also note that Gas Utilities industry companies like Naturgy Energy Group commonly do use debt without problems. Taking the abovementioned factors together we do think Naturgy Energy Group's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Naturgy Energy Group has 3 warning signs (and 1 which is concerning) we think you should know about.

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. 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.