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

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. 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?

What Risk Does Debt Bring?

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. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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.

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

How Much Debt Does Terna - Rete Elettrica Nazionale Società per Azioni Carry?

The image below, which you can click on for greater detail, shows that Terna - Rete Elettrica Nazionale Società per Azioni had debt of €11.1b at the end of June 2022, a reduction from €11.8b over a year. However, it also had €2.03b in cash, and so its net debt is €9.03b.

How Strong 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 €7.03b due within 12 months and liabilities of €10.4b due beyond that. Offsetting these obligations, it had cash of €2.03b as well as receivables valued at €3.82b due within 12 months. So it has liabilities totalling €11.6b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its very significant market capitalization of €14.3b, so it does suggest shareholders should keep an eye on Terna - Rete Elettrica Nazionale Società per Azioni's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe 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). 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).

Terna - Rete Elettrica Nazionale Società per Azioni's net debt is 4.9 times its EBITDA, which is a significant but still reasonable amount of leverage. But its EBIT was about 13.4 times its interest expense, implying the company isn't really paying a high cost to maintain that level of debt. Even were the low cost to prove unsustainable, that is a good sign. We saw Terna - Rete Elettrica Nazionale Società per Azioni grow its EBIT by 8.8% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we always check how much of that EBIT is translated into free cash flow. Considering the last three years, Terna - Rete Elettrica Nazionale Società per Azioni 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

To be frank both Terna - Rete Elettrica Nazionale Società per Azioni's net debt to EBITDA and its track record of converting EBIT to free cash flow make us rather uncomfortable with its debt levels. But on the bright side, its interest cover is a good sign, and makes us more optimistic. We should also note that Electric Utilities industry companies like Terna - Rete Elettrica Nazionale Società per Azioni commonly do use debt without problems. Looking at the balance sheet and taking into account all these factors, we do believe that debt is making Terna - Rete Elettrica Nazionale Società per Azioni 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. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately, every company can contain risks that exist outside of the balance sheet. Be aware that Terna - Rete Elettrica Nazionale Società per Azioni is showing 2 warning signs in our investment analysis , and 1 of those is potentially serious...

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.