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. As with many other companies Meridian Energy Limited (NZSE:MEL) makes use of debt. But the more important question is: how much risk is that debt creating?
When Is Debt A Problem?
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. 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 think about a company's use of debt, we first look at cash and debt together.
What Is Meridian Energy's Debt?
As you can see below, Meridian Energy had NZ$1.56b of debt, at December 2019, which is about the same the year before. You can click the chart for greater detail. However, it does have NZ$55.0m in cash offsetting this, leading to net debt of about NZ$1.50b.
How Healthy Is Meridian Energy's Balance Sheet?
We can see from the most recent balance sheet that Meridian Energy had liabilities of NZ$583.0m falling due within a year, and liabilities of NZ$3.70b due beyond that. Offsetting this, it had NZ$55.0m in cash and NZ$288.0m in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by NZ$3.94b.
This deficit isn't so bad because Meridian Energy is worth NZ$11.8b, and thus could probably raise enough capital to shore up its balance sheet, if the need arose. However, it is still worthwhile taking a close look at its ability to pay off debt.
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.
Meridian Energy's net debt is sitting at a very reasonable 1.6 times its EBITDA, while its EBIT covered its interest expense just 5.2 times last year. While these numbers do not alarm us, it's worth noting that the cost of the company's debt is having a real impact. It is well worth noting that Meridian Energy's EBIT shot up like bamboo after rain, gaining 43% in the last twelve months. That'll make it easier to manage its 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 Meridian 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 we clearly need to look at whether that EBIT is leading to corresponding free cash flow. During the last three years, Meridian Energy generated free cash flow amounting to a very robust 96% of its EBIT, more than we'd expect. That positions it well to pay down debt if desirable to do so.
Meridian Energy's conversion of EBIT to free cash flow suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. And that's just the beginning of the good news since its EBIT growth rate is also very heartening. Looking at the bigger picture, we think Meridian Energy's use of debt seems quite reasonable and we're not concerned about it. While debt does bring risk, when used wisely it can also bring a higher return on equity. 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. To that end, you should learn about the 3 warning signs we've spotted with Meridian Energy (including 2 which is are concerning) .
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.
If you spot an error that warrants correction, please contact the editor at firstname.lastname@example.org. This article by Simply Wall St is general in nature. It does not constitute a recommendation to buy or sell any stock, and does not take account of your objectives, or your financial situation. Simply Wall St has no position in the stocks mentioned.
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