Is Contact Energy (NZSE:CEN) A Risky Investment?

Howard Marks put it nicely when he said that, rather than worrying about share price volatility, 'The possibility of permanent loss is the risk I worry about... and every practical investor I know worries about.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. We can see that Contact Energy Limited (NZSE:CEN) does use debt in its business. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

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. 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. When we examine debt levels, we first consider both cash and debt levels, together.

Check out our latest analysis for Contact Energy

What Is Contact Energy's Net Debt?

As you can see below, at the end of December 2023, Contact Energy had NZ$1.90b of debt, up from NZ$1.37b a year ago. Click the image for more detail. However, it does have NZ$274.0m in cash offsetting this, leading to net debt of about NZ$1.62b.

How Healthy Is Contact Energy's Balance Sheet?

The latest balance sheet data shows that Contact Energy had liabilities of NZ$802.0m due within a year, and liabilities of NZ$2.57b falling due after that. On the other hand, it had cash of NZ$274.0m and NZ$219.0m worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$2.88b.

Contact Energy has a market capitalization of NZ$6.87b, so it could very likely raise cash to ameliorate its balance sheet, if the need arose. But we definitely want to keep our eyes open to indications that its debt is bringing too much risk.

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

Contact Energy's net debt to EBITDA ratio of about 2.4 suggests only moderate use of debt. And its commanding EBIT of 11.0 times its interest expense, implies the debt load is as light as a peacock feather. Pleasingly, Contact Energy is growing its EBIT faster than former Australian PM Bob Hawke downs a yard glass, boasting a 414% gain in the last twelve months. When analysing debt levels, the balance sheet is the obvious place to start. But it is future earnings, more than anything, that will determine Contact Energy'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.

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, Contact Energy 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.

Our View

Contact Energy's EBIT growth rate was a real positive on this analysis, as was its interest cover. In contrast, our confidence was undermined by its apparent struggle to convert EBIT to free cash flow. We would also note that Electric Utilities industry companies like Contact Energy commonly do use debt without problems. Considering this range of data points, we think Contact Energy is in a good position to manage its debt levels. Having said that, the load is sufficiently heavy that we would recommend any shareholders keep a close eye on it. 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. These risks can be hard to spot. Every company has them, and we've spotted 2 warning signs for Contact Energy (of which 1 is a bit concerning!) you should know about.

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.