Here's Why Terna - Rete Elettrica Nazionale Società per Azioni (BIT:TRN) Has A Meaningful Debt Burden

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 seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Terna - Rete Elettrica Nazionale Società per Azioni (BIT:TRN) does use debt in its business. But should shareholders be worried about its use of debt?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. 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 think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Terna - Rete Elettrica Nazionale Società per Azioni

What Is Terna - Rete Elettrica Nazionale Società per Azioni's Net Debt?

As you can see below, Terna - Rete Elettrica Nazionale Società per Azioni had €12.2b of debt, at September 2021, which is about the same as the year before. You can click the chart for greater detail. However, it does have €2.59b in cash offsetting this, leading to net debt of about €9.57b.

How Healthy Is Terna - Rete Elettrica Nazionale Società per Azioni's Balance Sheet?

Zooming in on the latest balance sheet data, we can see that Terna - Rete Elettrica Nazionale Società per Azioni had liabilities of €4.97b due within 12 months and liabilities of €9.49b due beyond that. On the other hand, it had cash of €2.59b and €450.2m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €11.4b.

This deficit is considerable relative to its very significant market capitalization of €13.4b, 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 5.3 but very strong interest coverage of 13.5. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Notably Terna - Rete Elettrica Nazionale Società per Azioni's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. 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 Terna - Rete Elettrica Nazionale Società per Azioni 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.

Finally, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Considering the last three years, Terna - Rete Elettrica Nazionale Società per Azioni actually recorded a cash outflow, overall. Debt is far more risky for companies with unreliable free cash flow, so shareholders should be hoping that the past expenditure will produce free cash flow in the future.

Our View

On the face of it, Terna - Rete Elettrica Nazionale Società per Azioni's net debt to EBITDA left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at covering its interest expense with its EBIT; that's encouraging. It's also worth noting that Terna - Rete Elettrica Nazionale Società per Azioni is in the Electric Utilities industry, which is often considered to be quite defensive. Looking at the bigger picture, it seems clear to us that Terna - Rete Elettrica Nazionale Società per Azioni's use of debt is creating risks for the company. If everything goes well that may pay off but the downside of this debt is a greater risk of permanent losses. 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. To that end, you should be aware of the 1 warning sign we've spotted with Terna - Rete Elettrica Nazionale Società per Azioni .

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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team (at) simplywallst.com.

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.