Is Energy Development (NSE:ENERGYDEV) A Risky Investment?

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.' 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 Energy Development Company Limited (NSE:ENERGYDEV) makes use of debt. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

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. 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. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest 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.

Check out our latest analysis for Energy Development

What Is Energy Development's Net Debt?

As you can see below, Energy Development had ₹1.59b of debt, at September 2020, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has ₹544.9m in cash leading to net debt of about ₹1.04b.

How Healthy Is Energy Development's Balance Sheet?

According to the last reported balance sheet, Energy Development had liabilities of ₹982.6m due within 12 months, and liabilities of ₹1.62b due beyond 12 months. Offsetting this, it had ₹544.9m in cash and ₹465.5m in receivables that were due within 12 months. So it has liabilities totalling ₹1.59b more than its cash and near-term receivables, combined.

This deficit casts a shadow over the ₹323.5m company, like a colossus towering over mere mortals. So we'd watch its balance sheet closely, without a doubt. After all, Energy Development would likely require a major re-capitalisation if it had to pay its creditors today.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Weak interest cover of 0.29 times and a disturbingly high net debt to EBITDA ratio of 6.6 hit our confidence in Energy Development like a one-two punch to the gut. The debt burden here is substantial. More concerning, Energy Development saw its EBIT drop by 4.9% in the last twelve months. If it keeps going like that paying off its debt will be like running on a treadmill -- a lot of effort for not much advancement. There's no doubt that we learn most about debt from the balance sheet. But you can't view debt in total isolation; since Energy Development will need earnings to service that debt. So when considering debt, it's definitely worth looking at the earnings trend. Click here for an interactive snapshot.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Happily for any shareholders, Energy Development actually produced more free cash flow than EBIT over the last three years. That sort of strong cash generation warms our hearts like a puppy in a bumblebee suit.

Our View

To be frank both Energy Development's interest cover and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its conversion of EBIT to free cash flow is a good sign, and makes us more optimistic. We should also note that Electric Utilities industry companies like Energy Development commonly do use debt without problems. Overall, we think it's fair to say that Energy Development has enough debt that there are some real risks around the balance sheet. If all goes well, that should boost returns, but on the flip side, the risk of permanent capital loss is elevated by the 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. Take risks, for example - Energy Development has 5 warning signs (and 2 which make us uncomfortable) we think 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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