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

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' 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. As with many other companies EDP - Energias de Portugal, S.A. (ELI:EDP) makes use of debt. But the more important question is: how much risk is that debt creating?

Why Does Debt Bring Risk?

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 frequent (but still costly) occurrence is where a company must issue shares at bargain-basement prices, permanently diluting shareholders, just to shore up its balance sheet. Of course, the upside of debt is that it often represents cheap capital, especially when it replaces dilution in a company with the ability to reinvest at high rates of return. 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 Net Debt?

As you can see below, EDP - Energias de Portugal had €21.6b of debt, at September 2023, which is about the same as the year before. You can click the chart for greater detail. On the flip side, it has €2.02b in cash leading to net debt of about €19.6b.

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

According to the last reported balance sheet, EDP - Energias de Portugal had liabilities of €15.0b due within 12 months, and liabilities of €26.2b due beyond 12 months. On the other hand, it had cash of €2.02b and €5.42b worth of receivables due within a year. So its liabilities total €33.8b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the €18.9b company itself, as if a child were struggling under the weight of an enormous back-pack full of books, his sports gear, and a trumpet. So we'd watch its balance sheet closely, without a doubt. 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). Thus we consider debt relative to earnings both with and without depreciation and amortization expenses.

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 3.8 is reasonably strong, which is a good sign. The silver lining is that EDP - Energias de Portugal grew its EBIT by 128% last year, which nourishing like the idealism of youth. If it can keep walking that path it will be in a position to shed its debt with relative ease. When analysing debt levels, the balance sheet is the obvious place to start. 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.

But our final consideration is also important, because a company cannot pay debt with paper profits; it needs cold hard cash. 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

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 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. 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. Be aware that EDP - Energias de Portugal is showing 3 warning signs in our investment analysis , and 1 of those makes us a bit uncomfortable...

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.