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 Terna - Rete Elettrica Nazionale Società per Azioni (BIT:TRN) makes use of debt. But is this debt a concern to shareholders?
When Is Debt A Problem?
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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Terna - Rete Elettrica Nazionale Società per Azioni's Debt?
The image below, which you can click on for greater detail, shows that at June 2020 Terna - Rete Elettrica Nazionale Società per Azioni had debt of €10.6b, up from €10.0b in one year. However, it does have €1.74b in cash offsetting this, leading to net debt of about €8.90b.
How Healthy Is Terna - Rete Elettrica Nazionale Società per Azioni's Balance Sheet?
The latest balance sheet data shows that Terna - Rete Elettrica Nazionale Società per Azioni had liabilities of €4.76b due within a year, and liabilities of €9.62b falling due after that. Offsetting these obligations, it had cash of €1.74b as well as receivables valued at €1.52b due within 12 months. So its liabilities total €11.1b more than the combination of its cash and short-term receivables.
This deficit is considerable relative to its very significant market capitalization of €12.4b, so it does suggest shareholders should keep an eye on Terna - Rete Elettrica Nazionale Società per Azioni'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 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.
As it happens Terna - Rete Elettrica Nazionale Società per Azioni has a fairly concerning net debt to EBITDA ratio of 5.1 but very strong interest coverage of 14.9. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. We saw Terna - Rete Elettrica Nazionale Società per Azioni grow its EBIT by 3.8% 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 - Rete Elettrica Nazionale Società per Azioni 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. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Terna - Rete Elettrica Nazionale Società per Azioni's free cash flow amounted to 21% of its EBIT, less than we'd expect. That's not great, when it comes to paying down debt.
Neither Terna - Rete Elettrica Nazionale Società per Azioni's ability handle its debt, based on its EBITDA, nor its level of total liabilities gave us confidence in its ability to take on more debt. But its interest cover tells a very different story, and suggests some resilience. We should also note that Electric Utilities industry companies like Terna - Rete Elettrica Nazionale Società per Azioni commonly do use debt without problems. When we consider all the factors discussed, it seems to us that Terna - Rete Elettrica Nazionale Società per Azioni is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. 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 instance, we've identified 2 warning signs for Terna - Rete Elettrica Nazionale Società per Azioni (1 can't be ignored) you should be aware of.
If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.
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This article by Simply Wall St is general in nature. 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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