These 4 Measures Indicate That Contact Energy (NZSE:CEN) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. We can see that Contact Energy Limited (NZSE:CEN) does use debt in its business. But is this debt a concern to shareholders?

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. 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, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for Contact Energy

How Much Debt Does Contact Energy Carry?

The image below, which you can click on for greater detail, shows that at June 2023 Contact Energy had debt of NZ$1.56b, up from NZ$1.07b in one year. On the flip side, it has NZ$140.0m in cash leading to net debt of about NZ$1.42b.

How Healthy Is Contact Energy's Balance Sheet?

The latest balance sheet data shows that Contact Energy had liabilities of NZ$780.0m due within a year, and liabilities of NZ$2.22b falling due after that. Offsetting this, it had NZ$140.0m in cash and NZ$249.0m in receivables that were due within 12 months. So its liabilities total NZ$2.62b more than the combination of its cash and short-term receivables.

Contact Energy has a market capitalization of NZ$6.73b, 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 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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Contact Energy's debt is 2.8 times its EBITDA, and its EBIT cover its interest expense 6.9 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We saw Contact Energy grow its EBIT by 4.8% in the last twelve months. That's far from incredible but it is a good thing, when it comes to paying off debt. 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 want to see what the professionals think, you might find this free report on analyst profit forecasts to be interesting.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So it's worth checking how much of that EBIT is backed by free cash flow. In the last three years, Contact Energy created free cash flow amounting to 16% of its EBIT, an uninspiring performance. That limp level of cash conversion undermines its ability to manage and pay down debt.

Our View

Both Contact Energy's conversion of EBIT to free cash flow and its net debt to EBITDA were discouraging. But its not so bad at covering its interest expense with its EBIT. It's also worth noting that Contact Energy is in the Electric Utilities industry, which is often considered to be quite defensive. We think that Contact Energy's debt does make it a bit risky, after considering the aforementioned data points together. Not all risk is bad, as it can boost share price returns if it pays off, but this debt risk is worth keeping in mind. 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. To that end, you should learn about the 2 warning signs we've spotted with Contact Energy (including 1 which is significant) .

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.