Does EDP - Energias de Portugal (ELI:EDP) Have A 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, EDP - Energias de Portugal, S.A. (ELI:EDP) does carry debt. But should shareholders be worried about its use of debt?

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. 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. Having said that, the most common situation is where a company manages its debt reasonably well - and to its own advantage. The first thing to do when considering how much debt a business uses is to look at its cash and debt together.

View our latest analysis for EDP - Energias de Portugal

What Is EDP - Energias de Portugal's Net Debt?

The image below, which you can click on for greater detail, shows that at September 2021 EDP - Energias de Portugal had debt of €17.2b, up from €16.2b in one year. However, because it has a cash reserve of €2.56b, its net debt is less, at about €14.6b.

A Look At EDP - Energias de Portugal's Liabilities

Zooming in on the latest balance sheet data, we can see that EDP - Energias de Portugal had liabilities of €9.79b due within 12 months and liabilities of €24.7b due beyond that. Offsetting this, it had €2.56b in cash and €4.64b in receivables that were due within 12 months. So its liabilities total €27.3b more than the combination of its cash and short-term receivables.

Given this deficit is actually higher than the company's massive market capitalization of €18.3b, we think shareholders really should watch EDP - Energias de Portugal's debt levels, like a parent watching their child ride a bike for the first time. Hypothetically, extremely heavy dilution would be required if the company were forced to pay down its liabilities by raising capital at the current share price.

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). 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).

With a net debt to EBITDA ratio of 5.1, it's fair to say EDP - Energias de Portugal does have a significant amount of debt. However, its interest coverage of 4.1 is reasonably strong, which is a good sign. On a lighter note, we note that EDP - Energias de Portugal grew its EBIT by 27% in the last year. If it can maintain that kind of improvement, its debt load will begin to melt away like glaciers in a warming world. The balance sheet is clearly the area to focus on when you are analysing debt. But it is future earnings, more than anything, that will determine EDP - Energias de Portugal'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, while the tax-man may adore accounting profits, lenders only accept cold hard cash. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Over the last three years, EDP - Energias de Portugal saw substantial negative free cash flow, in total. While that may be a result of expenditure for growth, it does make the debt far more risky.

Our View

On the face of it, EDP - Energias de Portugal's level of total liabilities left us tentative about the stock, and its conversion of EBIT to free cash flow was no more enticing than the one empty restaurant on the busiest night of the year. But at least it's pretty decent at growing its EBIT; that's encouraging. We should also note that Electric Utilities industry companies like EDP - Energias de Portugal commonly do use debt without problems. We're quite clear that we consider EDP - Energias de Portugal to be really rather risky, as a result of its balance sheet health. So we're almost as wary of this stock as a hungry kitten is about falling into its owner's fish pond: once bitten, twice shy, as they say. 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. For example - EDP - Energias de Portugal has 1 warning sign we think you should be aware of.

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.