We Think Chubu Electric Power Company (TSE:9502) Is Taking Some Risk With Its Debt

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.' 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, Chubu Electric Power Company, Incorporated (TSE:9502) does carry debt. But should shareholders be worried about its use of debt?

When Is Debt Dangerous?

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. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. However, a more common (but still painful) scenario is that it has to raise new equity capital at a low price, thus permanently diluting shareholders. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

See our latest analysis for Chubu Electric Power Company

What Is Chubu Electric Power Company's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of March 2024 Chubu Electric Power Company had JP¥3.07t of debt, an increase on JP¥2.91t, over one year. However, it does have JP¥390.8b in cash offsetting this, leading to net debt of about JP¥2.67t.

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

The latest balance sheet data shows that Chubu Electric Power Company had liabilities of JP¥1.30t due within a year, and liabilities of JP¥3.12t falling due after that. On the other hand, it had cash of JP¥390.8b and JP¥352.8b worth of receivables due within a year. So it has liabilities totalling JP¥3.67t more than its cash and near-term receivables, combined.

The deficiency here weighs heavily on the JP¥1.42t company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. After all, Chubu Electric Power Company would likely require a major re-capitalisation if it had to pay its creditors today.

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). 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 5.2 but very strong interest coverage of 17.3. So either it has access to very cheap long term debt or that interest expense is going to grow! Pleasingly, Chubu Electric Power Company is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 221% gain in the last twelve months. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine Chubu Electric Power Company'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 we always check how much of that EBIT is translated into free cash flow. In the last two years, Chubu Electric Power Company's free cash flow amounted to 32% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

While Chubu Electric Power Company's level of total liabilities has us nervous. To wit both its interest cover and EBIT growth rate were encouraging signs. It's also worth noting that Chubu Electric Power Company is in the Electric Utilities industry, which is often considered to be quite defensive. Taking the abovementioned factors together we do think Chubu Electric Power Company's debt poses some risks to the business. While that debt can boost returns, we think the company has enough leverage now. 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. We've identified 3 warning signs with Chubu Electric Power Company (at least 2 which are concerning) , and understanding them should be part of your investment process.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.

Have feedback on this article? Concerned about the content? Get in touch with us directly. Alternatively, email editorial-team@simplywallst.com