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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. As with many other companies Centrica plc (LON:CNA) makes use of debt. But should shareholders be worried about its use of debt?
When Is Debt Dangerous?
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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.
What Is Centrica's Debt?
You can click the graphic below for the historical numbers, but it shows that Centrica had UK£3.68b of debt in June 2021, down from UK£4.61b, one year before. However, its balance sheet shows it holds UK£3.73b in cash, so it actually has UK£54.0m net cash.
How Strong Is Centrica's Balance Sheet?
We can see from the most recent balance sheet that Centrica had liabilities of UK£6.88b falling due within a year, and liabilities of UK£7.23b due beyond that. Offsetting this, it had UK£3.73b in cash and UK£2.61b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by UK£7.76b.
This deficit casts a shadow over the UK£3.04b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. After all, Centrica would likely require a major re-capitalisation if it had to pay its creditors today. Given that Centrica has more cash than debt, we're pretty confident it can handle its debt, despite the fact that it has a lot of liabilities in total.
In addition to that, we're happy to report that Centrica has boosted its EBIT by 48%, thus reducing the spectre of future debt repayments. 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. 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 31% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
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£54.0m. And it impressed us with its EBIT growth of 48% over the last year. So although we see some areas for improvement, we're not too worried about Centrica's balance sheet. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for Centrica (1 doesn't sit too well with us!) that you should be aware of before investing here.
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.
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