We Think Naturgy Energy Group (BME:NTGY) Can Stay On Top Of Its 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.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We can see that Naturgy Energy Group, S.A. (BME:NTGY) does use debt in its business. 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. 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, debt can be an important tool in businesses, particularly capital heavy businesses. 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

How Much Debt Does Naturgy Energy Group Carry?

You can click the graphic below for the historical numbers, but it shows that Naturgy Energy Group had €16.7b of debt in March 2022, down from €17.6b, one year before. However, it does have €3.62b in cash offsetting this, leading to net debt of about €13.1b.

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 €11.6b due within 12 months and liabilities of €20.9b due beyond that. On the other hand, it had cash of €3.62b and €6.90b worth of receivables due within a year. So its liabilities total €22.0b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its very significant market capitalization of €27.2b, so it does suggest shareholders should keep an eye on Naturgy Energy Group's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Naturgy Energy Group's debt is 3.6 times its EBITDA, and its EBIT cover its interest expense 6.8 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. One way Naturgy Energy Group could vanquish its debt would be if it stops borrowing more but continues to grow EBIT at around 19%, as it did over the last year. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. In the last three years, Naturgy Energy Group's free cash flow amounted to 46% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Our View

On our analysis Naturgy Energy Group's EBIT growth rate should signal that it won't have too much trouble with its debt. But the other factors we noted above weren't so encouraging. For example, its net debt to EBITDA makes us a little nervous about its debt. We would also note that Gas Utilities industry companies like Naturgy Energy Group commonly do use debt without problems. Looking at all this data makes us feel a little cautious about Naturgy Energy Group's debt levels. While we appreciate debt can enhance returns on equity, we'd suggest that shareholders keep close watch on its debt levels, lest they increase. 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 .

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.