Is EDP - Energias de Portugal (ELI:EDP) A Risky Investment?

The external fund manager backed by Berkshire Hathaway's Charlie Munger, Li Lu, makes no bones about it when he says 'The biggest investment risk is not the volatility of prices, but whether you will suffer a permanent loss of capital.' 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, EDP - Energias de Portugal, S.A. (ELI:EDP) does carry debt. But the real question is whether this debt is making the company risky.

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. 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. 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 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

How Much Debt Does EDP - Energias de Portugal Carry?

The image below, which you can click on for greater detail, shows that EDP - Energias de Portugal had debt of €16.2b at the end of September 2020, a reduction from €17.1b over a year. On the flip side, it has €1.82b in cash leading to net debt of about €14.3b.

How Strong Is EDP - Energias de Portugal's Balance Sheet?

We can see from the most recent balance sheet that EDP - Energias de Portugal had liabilities of €8.19b falling due within a year, and liabilities of €20.1b due beyond that. Offsetting this, it had €1.82b in cash and €3.65b in receivables that were due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by €22.8b.

Given this deficit is actually higher than the company's massive market capitalization of €17.8b, 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 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).

EDP - Energias de Portugal has a debt to EBITDA ratio of 4.5 and its EBIT covered its interest expense 4.7 times. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. We note that EDP - Energias de Portugal grew its EBIT by 21% in the last year, and that should make it easier to pay down debt, going forward. 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 EDP - Energias de Portugal 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. In the last three years, EDP - Energias de Portugal's free cash flow amounted to 47% of its EBIT, less than we'd expect. That weak cash conversion makes it more difficult to handle indebtedness.

Our View

Both EDP - Energias de Portugal's level of total liabilities and its net debt to EBITDA were discouraging. But at least its EBIT growth rate is a gleaming silver lining to those clouds. We should also note that Electric Utilities industry companies like EDP - Energias de Portugal commonly do use debt without problems. When we consider all the factors discussed, it seems to us that EDP - Energias de Portugal is taking some risks with its use of debt. While that debt can boost returns, we think the company has enough leverage now. There's no doubt that we learn most about debt from the balance sheet. But ultimately, every company can contain risks that exist outside of the balance sheet. Like risks, for instance. Every company has them, and we've spotted 3 warning signs for EDP - Energias de Portugal (of which 1 makes us a bit uncomfortable!) 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. 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.
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