Meridian Energy (NZSE:MEL) Has A Pretty Healthy Balance Sheet

Legendary fund manager Li Lu (who Charlie Munger backed) once said, 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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. Importantly, Meridian Energy Limited (NZSE:MEL) does carry debt. But the more important question is: how much risk is that debt creating?

When Is Debt Dangerous?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. If things get really bad, the lenders can take control of the business. 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. 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.

Check out our latest analysis for Meridian Energy

How Much Debt Does Meridian Energy Carry?

As you can see below, at the end of June 2024, Meridian Energy had NZ$1.35b of debt, up from NZ$1.24b a year ago. Click the image for more detail. However, it also had NZ$221.0m in cash, and so its net debt is NZ$1.13b.

How Strong Is Meridian Energy's Balance Sheet?

We can see from the most recent balance sheet that Meridian Energy had liabilities of NZ$1.00b falling due within a year, and liabilities of NZ$4.29b due beyond that. Offsetting this, it had NZ$221.0m in cash and NZ$548.0m in receivables that were due within 12 months. So it has liabilities totalling NZ$4.53b more than its cash and near-term receivables, combined.

While this might seem like a lot, it is not so bad since Meridian Energy has a market capitalization of NZ$15.6b, 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.

In order to size up a company's debt relative to its earnings, we calculate its net debt divided by its earnings before interest, tax, depreciation, and amortization (EBITDA) and its earnings before interest and tax (EBIT) divided by its interest expense (its interest cover). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

Meridian Energy's net debt is only 1.2 times its EBITDA. And its EBIT covers its interest expense a whopping 11.0 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. Even more impressive was the fact that Meridian Energy grew its EBIT by 337% over twelve months. That boost will make it even easier to pay down debt going forward. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Meridian Energy can strengthen its balance sheet over time. So if you're focused on the future you can check out this free report showing analyst profit forecasts.

Finally, a business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. During the last three years, Meridian Energy produced sturdy free cash flow equating to 59% of its EBIT, about what we'd expect. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

The good news is that Meridian Energy's demonstrated ability to grow its EBIT delights us like a fluffy puppy does a toddler. And the good news does not stop there, as its interest cover also supports that impression! Looking at the bigger picture, we think Meridian Energy's use of debt seems quite reasonable and we're not concerned about it. After all, sensible leverage can boost returns on equity. 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 1 warning sign for Meridian Energy 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.