Chubu Electric Power Company (TSE:9502) Seems To Be Using A Lot Of Debt

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.' 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, Chubu Electric Power Company, Incorporated (TSE:9502) does carry debt. 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. If things get really bad, the lenders can take control of the business. 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, debt can be an important tool in businesses, particularly capital heavy businesses. The first step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Chubu Electric Power Company

What Is Chubu Electric Power Company's Debt?

As you can see below, Chubu Electric Power Company had JP¥3.11t of debt, at September 2024, which is about the same as the year before. You can click the chart for greater detail. However, it does have JP¥285.2b in cash offsetting this, leading to net debt of about JP¥2.82t.

How Strong Is Chubu Electric Power Company's Balance Sheet?

According to the last reported balance sheet, Chubu Electric Power Company had liabilities of JP¥1.21t due within 12 months, and liabilities of JP¥3.03t due beyond 12 months. Offsetting this, it had JP¥285.2b in cash and JP¥325.8b in receivables that were due within 12 months. So its liabilities total JP¥3.62t more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the JP¥1.24t company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, Chubu Electric Power Company would probably need a major re-capitalization if its creditors were to demand repayment.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

As it happens Chubu Electric Power Company has a fairly concerning net debt to EBITDA ratio of 6.8 but very strong interest coverage of 11.3. This means that unless the company has access to very cheap debt, that interest expense will likely grow in the future. Unfortunately, Chubu Electric Power Company's EBIT flopped 18% over the last four quarters. If earnings continue to decline at that rate then handling the debt will be more difficult than taking three children under 5 to a fancy pants restaurant. The balance sheet is clearly the area to focus on when you are analysing debt. But ultimately the future profitability of the business will decide if Chubu Electric Power Company 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, 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. Looking at the most recent two years, Chubu Electric Power Company recorded free cash flow of 28% of its EBIT, which is weaker than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

To be frank both Chubu Electric Power Company's net debt to EBITDA and its track record of staying on top of its total liabilities 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 Chubu Electric Power Company commonly do use debt without problems. We're quite clear that we consider Chubu Electric Power Company to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. We've identified 3 warning signs with Chubu Electric Power Company (at least 2 which can't be ignored) , and understanding them should be part of your investment process.

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.