Terna Energy Societe Anonyme Commercial Technical (ATH:TENERGY) Takes On Some Risk With Its Use Of Debt

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.' 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. We can see that Terna Energy Societe Anonyme Commercial Technical Company (ATH:TENERGY) does use debt in its business. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. If things get really bad, the lenders can take control of the business. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

View our latest analysis for Terna Energy Societe Anonyme Commercial Technical

What Is Terna Energy Societe Anonyme Commercial Technical's Debt?

As you can see below, at the end of September 2022, Terna Energy Societe Anonyme Commercial Technical had €1.09b of debt, up from €855.6m a year ago. Click the image for more detail. However, it does have €428.1m in cash offsetting this, leading to net debt of about €657.8m.

A Look At Terna Energy Societe Anonyme Commercial Technical's Liabilities

The latest balance sheet data shows that Terna Energy Societe Anonyme Commercial Technical had liabilities of €211.1m due within a year, and liabilities of €1.38b falling due after that. On the other hand, it had cash of €428.1m and €107.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €1.05b.

Terna Energy Societe Anonyme Commercial Technical has a market capitalization of €2.22b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We measure a company's debt load relative to its earnings power by looking at its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and by calculating how easily its earnings before interest and tax (EBIT) cover its interest expense (interest cover). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Terna Energy Societe Anonyme Commercial Technical has a debt to EBITDA ratio of 3.4 and its EBIT covered its interest expense 5.2 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We saw Terna Energy Societe Anonyme Commercial Technical grow its EBIT by 2.6% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Terna Energy Societe Anonyme Commercial Technical can strengthen its balance sheet over time. So if you want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Terna Energy Societe Anonyme Commercial Technical actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

We'd go so far as to say Terna Energy Societe Anonyme Commercial Technical's conversion of EBIT to free cash flow was disappointing. Having said that, its ability to grow its EBIT isn't such a worry. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Terna Energy Societe Anonyme Commercial Technical stock a bit risky. Some people like that sort of risk, but we're mindful of the potential pitfalls, so we'd probably prefer it carry less debt. 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. For instance, we've identified 3 warning signs for Terna Energy Societe Anonyme Commercial Technical (2 are a bit concerning) 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.