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

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.' So it seems the smart money knows that debt - which is usually involved in bankruptcies - is a very important factor, when you assess how risky a company is. Importantly, EDP - Energias de Portugal, S.A. (ELI:EDP) does carry debt. But should shareholders be worried about its use of debt?

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, plenty of companies use debt to fund growth, without any negative consequences. When we think about a company's use of debt, we first look at cash and debt together.

Check out 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 at September 2022 EDP - Energias de Portugal had debt of €21.5b, up from €17.2b in one year. On the flip side, it has €3.58b in cash leading to net debt of about €17.9b.

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

Zooming in on the latest balance sheet data, we can see that EDP - Energias de Portugal had liabilities of €18.4b due within 12 months and liabilities of €31.5b due beyond that. On the other hand, it had cash of €3.58b and €6.86b worth of receivables due within a year. So its liabilities outweigh the sum of its cash and (near-term) receivables by €39.5b.

This deficit casts a shadow over the €18.2b company, like a colossus towering over mere mortals. So we definitely think shareholders need to watch this one closely. At the end of the day, EDP - Energias de Portugal would probably need a major re-capitalization if its creditors were to demand repayment.

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). This way, we consider both the absolute quantum of the debt, as well as the interest rates paid on it.

Weak interest cover of 2.2 times and a disturbingly high net debt to EBITDA ratio of 6.1 hit our confidence in EDP - Energias de Portugal like a one-two punch to the gut. The debt burden here is substantial. Fortunately, EDP - Energias de Portugal grew its EBIT by 9.8% in the last year, slowly shrinking its debt relative to earnings. 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'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 we always check how much of that EBIT is translated into free cash flow. During the last three years, EDP - Energias de Portugal burned a lot of cash. While investors are no doubt expecting a reversal of that situation in due course, it clearly does mean its use of debt is more risky.

Our View

To be frank both EDP - Energias de Portugal's conversion of EBIT to free cash flow and its track record of staying on top of its total liabilities make us rather uncomfortable with its debt levels. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. It's also worth noting that EDP - Energias de Portugal is in the Electric Utilities industry, which is often considered to be quite defensive. After considering the datapoints discussed, we think EDP - Energias de Portugal has too much debt. While some investors love that sort of risky play, it's certainly not our cup of tea. When analysing debt levels, the balance sheet is the obvious place to start. 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 4 warning signs for EDP - Energias de Portugal (of which 2 make us uncomfortable!) you should know about.

If, after all that, you're more interested in a fast growing company with a rock-solid balance sheet, then check out our list of net cash growth stocks without delay.

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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.