Stock Analysis

Here's Why Galp Energia SGPS (ELI:GALP) Can Manage Its Debt Responsibly

ENXTLS:GALP
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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.' 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. Importantly, Galp Energia, SGPS, S.A. (ELI:GALP) does carry debt. But is this debt a concern to shareholders?

What Risk Does Debt Bring?

Debt and other liabilities become risky for a business when it cannot easily fulfill those obligations, either with free cash flow or by raising capital at an attractive price. If things get really bad, the lenders can take control of the business. However, a more usual (but still expensive) situation is where a company must dilute shareholders at a cheap share price simply to get debt under control. Of course, debt can be an important tool in businesses, particularly capital heavy businesses. When we examine debt levels, we first consider both cash and debt levels, together.

See our latest analysis for Galp Energia SGPS

How Much Debt Does Galp Energia SGPS Carry?

As you can see below, at the end of March 2022, Galp Energia SGPS had €5.03b of debt, up from €3.29b a year ago. Click the image for more detail. However, it does have €4.24b in cash offsetting this, leading to net debt of about €793.0m.

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ENXTLS:GALP Debt to Equity History June 20th 2022

How Strong Is Galp Energia SGPS' Balance Sheet?

According to the last reported balance sheet, Galp Energia SGPS had liabilities of €7.26b due within 12 months, and liabilities of €6.08b due beyond 12 months. On the other hand, it had cash of €4.24b and €2.99b worth of receivables due within a year. So it has liabilities totalling €6.12b more than its cash and near-term receivables, combined.

This deficit is considerable relative to its market capitalization of €9.27b, so it does suggest shareholders should keep an eye on Galp Energia SGPS' use of debt. This suggests shareholders would be heavily diluted if the company needed to shore up its balance sheet in a hurry.

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). 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 has a low net debt to EBITDA ratio of only 0.28. And its EBIT covers its interest expense a whopping 21.4 times over. So we're pretty relaxed about its super-conservative use of debt. Even more impressive was the fact that Galp Energia SGPS grew its EBIT by 909% over twelve months. That boost will make it even easier to pay down debt going forward. 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 Galp Energia SGPS 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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So we clearly need to look at whether that EBIT is leading to corresponding free cash flow. Looking at the most recent three years, Galp Energia SGPS recorded free cash flow of 37% of its EBIT, which is weaker than we'd expect. That's not great, when it comes to paying down debt.

Our View

Happily, Galp Energia SGPS's impressive interest cover 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. Looking at all the aforementioned factors together, it strikes us that Galp Energia SGPS can handle its debt fairly comfortably. On the plus side, this leverage can boost shareholder returns, but the potential downside is more risk of loss, so it's worth monitoring the balance sheet. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately, every company can contain risks that exist outside of the balance sheet. These risks can be hard to spot. Every company has them, and we've spotted 1 warning sign for Galp Energia SGPS 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.