Is Centrica (LON:CNA) A Risky Investment?

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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, Centrica plc (LON:CNA) does carry debt. But should shareholders be worried about its use of debt?

Why Does Debt Bring Risk?

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. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View 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. But it also has UK£7.04b in cash to offset that, meaning it has UK£3.11b net cash.

How Healthy Is Centrica's Balance Sheet?

We can see from the most recent balance sheet that Centrica had liabilities of UK£11.8b falling due within a year, and liabilities of UK£5.73b due beyond that. 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£7.88b, 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.

Although Centrica made a loss at the EBIT level, last year, it was also good to see that it generated UK£18b in EBIT over the last twelve months. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Centrica 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 company can only pay off debt with cold hard cash, not accounting profits. 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 year, Centrica created free cash flow amounting to 18% of its EBIT, an uninspiring performance. 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. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. For example - Centrica has 2 warning signs we think you should be aware of.

Of course, if you're the type of investor who prefers buying stocks without the burden of debt, then don't hesitate to discover our exclusive list of net cash growth stocks, today.

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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.