Centrica (LON:CNA) Seems To Use Debt Quite Sensibly

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the 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. We note that Centrica plc (LON:CNA) does have debt on its balance sheet. But should shareholders be worried about its use of debt?

When Is Debt A Problem?

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 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 Centrica

What Is Centrica's Debt?

The image below, which you can click on for greater detail, shows that at June 2023 Centrica had debt of UK£3.93b, up from UK£3.51b in one year. However, it does have UK£7.04b in cash offsetting this, leading to net cash of UK£3.11b.

A Look At Centrica's Liabilities

According to the last reported balance sheet, Centrica had liabilities of UK£11.8b due within 12 months, and liabilities of UK£5.73b due beyond 12 months. Offsetting these obligations, it had cash of UK£7.04b as well as receivables valued at UK£4.58b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£5.87b.

This deficit is considerable relative to its very significant market capitalization of UK£8.02b, so it does suggest shareholders should keep an eye on Centrica's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry. While it does have liabilities worth noting, Centrica also has more cash than debt, so we're pretty confident it can manage its debt safely.

It was also good to see that despite losing money on the EBIT line last year, Centrica turned things around in the last 12 months, delivering and EBIT of UK£18b. There's no doubt that we learn most about debt from the balance sheet. 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. While Centrica has net cash on its balance sheet, it's still worth taking a look at its ability to convert earnings before interest and tax (EBIT) to free cash flow, to help us understand how quickly it is building (or eroding) that cash balance. Over the last year, Centrica reported free cash flow worth 18% of its EBIT, which is really quite low. That limp level of cash conversion undermines its ability to manage and pay down debt.

Summing Up

While Centrica does have more liabilities than liquid assets, it also has net cash of UK£3.11b. So we don't have any problem with Centrica's use of debt. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example, we've discovered 2 warning signs for Centrica that you should be aware of before investing here.

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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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.