These 4 Measures Indicate That Genesis Energy (NZSE:GNE) Is Using Debt Reasonably Well

Some say volatility, rather than debt, is the best way to think about risk as an investor, but Warren Buffett famously said that 'Volatility is far from synonymous with risk.' 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 note that Genesis Energy Limited (NZSE:GNE) does have debt on its balance sheet. But is this debt a concern to shareholders?

When Is Debt Dangerous?

Generally speaking, debt only becomes a real problem when a company can't easily pay it off, either by raising capital or with its own cash flow. Part and parcel of capitalism is the process of 'creative destruction' where failed businesses are mercilessly liquidated by their bankers. While that is not too common, we often do see indebted companies permanently diluting shareholders because lenders force them to raise capital at a distressed price. By replacing dilution, though, debt can be an extremely good tool for businesses that need capital to invest in growth 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 Genesis Energy

What Is Genesis Energy's Debt?

The chart below, which you can click on for greater detail, shows that Genesis Energy had NZ$1.33b in debt in June 2021; about the same as the year before. However, because it has a cash reserve of NZ$104.3m, its net debt is less, at about NZ$1.23b.

How Strong Is Genesis Energy's Balance Sheet?

According to the last reported balance sheet, Genesis Energy had liabilities of NZ$1.18b due within 12 months, and liabilities of NZ$2.01b due beyond 12 months. On the other hand, it had cash of NZ$104.3m and NZ$354.5m worth of receivables due within a year. So its liabilities total NZ$2.73b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its market capitalization of NZ$3.01b, so it does suggest shareholders should keep an eye on Genesis Energy's use of debt. Should its lenders demand that it shore up the balance sheet, shareholders would likely face severe dilution.

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). The advantage of this approach is that we take into account both the absolute quantum of debt (with net debt to EBITDA) and the actual interest expenses associated with that debt (with its interest cover ratio).

Genesis Energy has a debt to EBITDA ratio of 3.2 and its EBIT covered its interest expense 3.9 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. Looking on the bright side, Genesis Energy boosted its EBIT by a silky 47% in the last year. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. 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 Genesis Energy 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 it's worth checking how much of that EBIT is backed by free cash flow. Happily for any shareholders, Genesis Energy actually produced more free cash flow than EBIT over the last three years. That sort of strong cash conversion gets us as excited as the crowd when the beat drops at a Daft Punk concert.

Our View

Happily, Genesis Energy's impressive conversion of EBIT to free cash flow implies it has the upper hand on its debt. But truth be told we feel its level of total liabilities does undermine this impression a bit. It's also worth noting that Genesis Energy is in the Electric Utilities industry, which is often considered to be quite defensive. Looking at all the aforementioned factors together, it strikes us that Genesis Energy can handle its debt fairly comfortably. Of course, while this leverage can enhance returns on equity, it does bring more risk, so it's worth keeping an eye on this one. When analysing debt levels, the balance sheet is the obvious place to start. However, not all investment risk resides within the balance sheet - far from it. We've identified 5 warning signs with Genesis Energy (at least 1 which makes us a bit uncomfortable) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.