These 4 Measures Indicate That Terna - Rete Elettrica Nazionale Società per Azioni (BIT:TRN) Is Using Debt Extensively

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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. 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?

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. However, a more frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth at high rates of return. When we examine debt levels, we first consider both cash and debt levels, together.

View 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 at June 2021 Terna - Rete Elettrica Nazionale Società per Azioni had debt of €11.8b, up from €10.6b in one year. On the flip side, it has €1.98b in cash leading to net debt of about €9.77b.

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 €4.74b due within 12 months, and liabilities of €10.8b due beyond 12 months. Offsetting these obligations, it had cash of €1.98b as well as receivables valued at €1.80b due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €11.8b.

This is a mountain of leverage even relative to its gargantuan market capitalization of €13.5b. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Strangely Terna - Rete Elettrica Nazionale Società per Azioni has a sky high EBITDA ratio of 5.5, implying high debt, but a strong interest coverage of 12.8. So either it has access to very cheap long term debt or that interest expense is going to grow! Importantly Terna - Rete Elettrica Nazionale Società per Azioni's EBIT was essentially flat over the last twelve months. We would prefer to see some earnings growth, because that always helps diminish 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.

Finally, a company can only pay off debt with cold hard cash, not accounting profits. So we always check how much of that EBIT is translated into free cash flow. Over the last three years, Terna - Rete Elettrica Nazionale Società per Azioni recorded negative free cash flow, in total. 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

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. 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. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Terna - Rete Elettrica Nazionale Società per Azioni 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.

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.

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