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

Warren Buffett famously said, '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 note that Contact Energy Limited (NZSE:CEN) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

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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, debt can be an important tool in businesses, particularly capital heavy businesses. When we think about a company's use of debt, we first look at cash and debt together.

What Is Contact Energy's Net Debt?

You can click the graphic below for the historical numbers, but it shows that as of December 2024 Contact Energy had NZ$2.10b of debt, an increase on NZ$1.56b, over one year. However, it also had NZ$216.0m in cash, and so its net debt is NZ$1.88b.

How Strong Is Contact Energy's Balance Sheet?

According to the last reported balance sheet, Contact Energy had liabilities of NZ$926.0m due within 12 months, and liabilities of NZ$2.81b due beyond 12 months. Offsetting these obligations, it had cash of NZ$216.0m as well as receivables valued at NZ$213.0m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$3.31b.

While this might seem like a lot, it is not so bad since Contact Energy has a market capitalization of NZ$7.22b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

Check out our latest analysis for Contact Energy

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 of 2.5 times EBITDA suggests graceful use of debt. And the fact that its trailing twelve months of EBIT was 8.8 times its interest expenses harmonizes with that theme. Notably Contact Energy's EBIT was pretty flat over the last year. Ideally it can diminish its debt load by kick-starting earnings growth. 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 Contact Energy'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. Over the last three years, Contact Energy recorded negative free cash flow, in total. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Contact Energy's struggle to convert EBIT to free cash flow had us second guessing its balance sheet strength, but the other data-points we considered were relatively redeeming. But on the bright side, its ability to to cover its interest expense with its EBIT isn't too shabby at all. It's also worth noting that Contact Energy is in the Electric Utilities industry, which is often considered to be quite defensive. When we consider all the factors discussed, it seems to us that Contact Energy is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example Contact Energy has 3 warning signs (and 1 which is potentially serious) we think 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.

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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.