Legendary fund manager Li Lu (who Charlie Munger backed) once said, '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. Importantly, Terna - Rete Elettrica Nazionale Società per Azioni (BIT:TRN) does carry debt. But is this debt a concern to shareholders?
When Is Debt Dangerous?
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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, plenty of companies use debt to fund growth, without any negative consequences. When we examine debt levels, we first consider both cash and debt levels, together.
What Is Terna - Rete Elettrica Nazionale Società per Azioni's Net Debt?
You can click the graphic below for the historical numbers, but it shows that as of September 2020 Terna - Rete Elettrica Nazionale Società per Azioni had €11.8b of debt, an increase on €10.7b, over one year. However, it does have €3.00b in cash offsetting this, leading to net debt of about €8.80b.
How Strong Is Terna - Rete Elettrica Nazionale Società per Azioni's Balance Sheet?
According to the last reported balance sheet, Terna - Rete Elettrica Nazionale Società per Azioni had liabilities of €4.18b due within 12 months, and liabilities of €9.82b due beyond 12 months. On the other hand, it had cash of €3.00b and €201.1m worth of receivables due within a year. So it has liabilities totalling €10.8b more than its cash and near-term receivables, combined.
This is a mountain of leverage even relative to its gargantuan market capitalization of €12.2b. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.
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). 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 5.0 times its EBITDA, which is a significant but still reasonable amount of leverage. However, its interest coverage of 13.9 is very high, suggesting that the interest expense on the debt is currently quite low. We saw Terna - Rete Elettrica Nazionale Società per Azioni grow its EBIT by 4.9% in the last twelve months. Whilst that hardly knocks our socks off it is a positive when it comes to debt. There's no doubt that we learn most about debt from the balance sheet. But it is future earnings, more than anything, that will determine Terna - Rete Elettrica Nazionale Società per Azioni's ability to maintain a healthy balance sheet going forward. 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 - 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.
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. Once we consider all the factors above, together, it seems to us that Terna - Rete Elettrica Nazionale Società per Azioni's debt is making it 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 2 warning signs for Terna - Rete Elettrica Nazionale Società per Azioni (1 is a bit unpleasant) 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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