Is EDP - Energias de Portugal (ELI:EDP) Using Too Much Debt?

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.' So it might be obvious that you need to consider debt, when you think about how risky any given stock is, because too much debt can sink a company. We note that EDP - Energias de Portugal, S.A. (ELI:EDP) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

Why Does Debt Bring Risk?

Debt assists a business until the business has trouble paying it off, either with new capital or with free 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. Of course, plenty of companies use debt to fund growth, without any negative consequences. The first step when considering a company's debt levels is to consider its cash and debt together.

See our latest analysis for EDP - Energias de Portugal

What Is EDP - Energias de Portugal's Debt?

You can click the graphic below for the historical numbers, but it shows that as of June 2023 EDP - Energias de Portugal had €21.1b of debt, an increase on €20.0b, over one year. However, it does have €3.13b in cash offsetting this, leading to net debt of about €18.0b.

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

The latest balance sheet data shows that EDP - Energias de Portugal had liabilities of €14.2b due within a year, and liabilities of €27.2b falling due after that. On the other hand, it had cash of €3.13b and €5.15b worth of receivables due within a year. So its liabilities total €33.1b more than the combination of its cash and short-term receivables.

This deficit casts a shadow over the €17.3b 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.

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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

EDP - Energias de Portugal's debt is 4.7 times its EBITDA, and its EBIT cover its interest expense 3.8 times over. Taken together this implies that, while we wouldn't want to see debt levels rise, we think it can handle its current leverage. However, it should be some comfort for shareholders to recall that EDP - Energias de Portugal actually grew its EBIT by a hefty 132%, over the last 12 months. If that earnings trend continues it will make its debt load much more manageable in the future. There's no doubt that we learn most about debt from the balance sheet. 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, a company can only pay off debt with cold hard cash, not accounting profits. 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 conversion of EBIT to free cash flow left us tentative about the stock, and its level of total liabilities was no more enticing than the one empty restaurant on the busiest night of the year. But on the bright side, its EBIT growth rate is a good sign, and makes us more optimistic. We should also note that Electric Utilities industry companies like EDP - Energias de Portugal commonly do use debt without problems. Overall, it seems to us that EDP - Energias de Portugal's balance sheet is really quite a risk to the business. 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. However, not all investment risk resides within the balance sheet - far from it. For example, we've discovered 3 warning signs for EDP - Energias de Portugal (2 are significant!) 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.