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. Importantly, SSE plc (LON:SSE) does carry debt. But the real question is whether this debt is making the company risky.
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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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. When we think about a company's use of debt, we first look at cash and debt together.
How Much Debt Does SSE Carry?
The image below, which you can click on for greater detail, shows that SSE had debt of UK£9.21b at the end of September 2021, a reduction from UK£9.63b over a year. However, because it has a cash reserve of UK£232.7m, its net debt is less, at about UK£8.97b.
How Healthy Is SSE's Balance Sheet?
The latest balance sheet data shows that SSE had liabilities of UK£5.57b due within a year, and liabilities of UK£10.7b falling due after that. Offsetting this, it had UK£232.7m in cash and UK£1.67b in receivables that were due within 12 months. So its liabilities total UK£14.4b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its very significant market capitalization of UK£17.5b, so it does suggest shareholders should keep an eye on SSE's use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.
We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).
SSE has net debt to EBITDA of 2.6 suggesting it uses a fair bit of leverage to boost returns. But the high interest coverage of 9.9 suggests it can easily service that debt. Pleasingly, SSE is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 151% gain in the last twelve months. 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 SSE's ability to maintain a healthy balance sheet going forward. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.
Finally, while the tax-man may adore accounting profits, lenders only accept 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, SSE created free cash flow amounting to 17% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.
On our analysis SSE'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 instance it seems like it has to struggle a bit to convert EBIT to free cash flow. We would also note that Electric Utilities industry companies like SSE commonly do use debt without problems. Looking at all this data makes us feel a little cautious about SSE's debt levels. While debt does have its upside in higher potential returns, we think shareholders should definitely consider how debt levels might make the stock more risky. 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. These risks can be hard to spot. Every company has them, and we've spotted 5 warning signs for SSE (of which 2 make us uncomfortable!) you should know about.
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.