Galp Energia SGPS (ELI:GALP) Seems To Use Debt Quite Sensibly

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.' It's only natural to consider a company's balance sheet when you examine how risky it is, since debt is often involved when a business collapses. We note that Galp Energia, SGPS, S.A. (ELI:GALP) does have debt on its balance sheet. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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. Ultimately, if the company can't fulfill its legal obligations to repay debt, shareholders could walk away with nothing. 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 step when considering a company's debt levels is to consider its cash and debt together.

Check out our latest analysis for Galp Energia SGPS

What Is Galp Energia SGPS's Debt?

You can click the graphic below for the historical numbers, but it shows that Galp Energia SGPS had €3.38b of debt in March 2023, down from €5.03b, one year before. However, it also had €2.04b in cash, and so its net debt is €1.34b.

How Healthy Is Galp Energia SGPS' Balance Sheet?

We can see from the most recent balance sheet that Galp Energia SGPS had liabilities of €3.64b falling due within a year, and liabilities of €6.37b due beyond that. On the other hand, it had cash of €2.04b and €2.23b worth of receivables due within a year. So its liabilities total €5.75b more than the combination of its cash and short-term receivables.

This deficit is considerable relative to its very significant market capitalization of €9.37b, so it does suggest shareholders should keep an eye on Galp Energia SGPS' 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).

Galp Energia SGPS's net debt is only 0.33 times its EBITDA. And its EBIT covers its interest expense a whopping 71.1 times over. So you could argue it is no more threatened by its debt than an elephant is by a mouse. In addition to that, we're happy to report that Galp Energia SGPS has boosted its EBIT by 68%, thus reducing the spectre of future debt repayments. There's no doubt that we learn most about debt from the balance sheet. But ultimately the future profitability of the business will decide if Galp Energia SGPS 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.

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 most recent three years, Galp Energia SGPS recorded free cash flow worth 52% of its EBIT, which is around normal, given free cash flow excludes interest and tax. This free cash flow puts the company in a good position to pay down debt, when appropriate.

Our View

Galp Energia SGPS's interest cover suggests it can handle its debt as easily as Cristiano Ronaldo could score a goal against an under 14's goalkeeper. But truth be told we feel its level of total liabilities does undermine this impression a bit. Taking all this data into account, it seems to us that Galp Energia SGPS takes a pretty sensible approach to debt. While that brings some risk, it can also enhance returns for shareholders. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 2 warning signs for Galp Energia SGPS (1 is potentially serious!) that you should be aware of before investing here.

When all is said and done, sometimes its easier to focus on companies that don't even need debt. Readers can access a list of growth stocks with zero net debt 100% free, right now.

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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.