Centrica (LON:CNA) Has A Pretty Healthy Balance Sheet

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.' 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 Centrica plc (LON:CNA) does have debt on its balance sheet. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Centrica

What Is Centrica's Net Debt?

As you can see below, Centrica had UK£3.69b of debt at December 2022, down from UK£4.28b a year prior. However, it does have UK£4.84b in cash offsetting this, leading to net cash of UK£1.15b.

How Strong Is Centrica's Balance Sheet?

We can see from the most recent balance sheet that Centrica had liabilities of UK£21.7b falling due within a year, and liabilities of UK£6.05b due beyond that. On the other hand, it had cash of UK£4.84b and UK£7.10b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£15.8b.

This deficit casts a shadow over the UK£6.41b company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. At the end of the day, Centrica would probably need a major re-capitalization if its creditors were to demand repayment. Centrica boasts net cash, so it's fair to say it does not have a heavy debt load, even if it does have very significant liabilities, in total.

Better yet, Centrica grew its EBIT by 3,304% last year, which is an impressive improvement. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Centrica's ability to maintain a healthy balance sheet going forward. 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. Centrica may have net cash on the balance sheet, but it is still interesting to look at how well the business converts its earnings before interest and tax (EBIT) to free cash flow, because that will influence both its need for, and its capacity to manage debt. In the last three years, Centrica's free cash flow amounted to 29% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.

Summing Up

Although Centrica's balance sheet isn't particularly strong, due to the total liabilities, it is clearly positive to see that it has net cash of UK£1.15b. And it impressed us with its EBIT growth of 3,304% over the last year. So we are not troubled with Centrica's debt use. 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. We've identified 1 warning sign with Centrica , and understanding them should be part of your investment process.

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.