Terna (BIT:TRN) Has A Somewhat Strained Balance Sheet

David Iben put it well when he said, 'Volatility is not a risk we care about. What we care about is avoiding the permanent loss of capital.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. Importantly, Terna S.p.A. (BIT:TRN) does carry debt. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. 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. 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. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Terna

What Is Terna's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2024 Terna had €12.8b of debt, an increase on €12.1b, over one year. On the flip side, it has €2.51b in cash leading to net debt of about €10.3b.

A Look At Terna's Liabilities

Zooming in on the latest balance sheet data, we can see that Terna had liabilities of €5.52b due within 12 months and liabilities of €12.0b due beyond that. Offsetting these obligations, it had cash of €2.51b as well as receivables valued at €2.39b due within 12 months. So its liabilities total €12.7b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its very significant market capitalization of €16.3b, so it does suggest shareholders should keep an eye on Terna'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). 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 has a debt to EBITDA ratio of 4.4, which signals significant debt, but is still pretty reasonable for most types of business. But its EBIT was about 13.2 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. If Terna can keep growing EBIT at last year's rate of 16% over the last year, then it will find its debt load easier to manage. 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's ability to maintain a healthy balance sheet going forward. 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Over the last three years, Terna saw substantial negative free cash flow, in total. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

Neither Terna's ability to convert EBIT to free cash flow nor its net debt to EBITDA 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 commonly do use debt without problems. Taking the abovementioned factors together we do think Terna's debt poses some risks to the business. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. For example Terna has 2 warning signs (and 1 which makes us a bit uncomfortable) we think you should know about.

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. 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.