These 4 Measures Indicate That EDP - Energias de Portugal (ELI:EDP) Is Using Debt Extensively

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. We can see that EDP - Energias de Portugal, S.A. (ELI:EDP) does use debt in its business. But the more important question is: how much risk is that debt creating?

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. 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?

The chart below, which you can click on for greater detail, shows that EDP - Energias de Portugal had €21.4b in debt in December 2023; about the same as the year before. However, because it has a cash reserve of €3.38b, its net debt is less, at about €18.0b.

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 €13.4b due within 12 months and liabilities of €26.7b due beyond that. Offsetting this, it had €3.38b in cash and €5.38b in receivables that were due within 12 months. So its liabilities total €31.3b more than the combination of its cash and short-term receivables.

The deficiency here weighs heavily on the €16.0b 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 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). 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's debt is 4.6 times its EBITDA, and its EBIT cover its interest expense 3.4 times over. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. On the other hand, 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 ultimately the future profitability of the business will decide if EDP - Energias de Portugal can strengthen its balance sheet over time. 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 we always check how much of that EBIT is translated into free cash flow. Over the last three years, EDP - Energias de Portugal saw substantial negative free cash flow, in total. 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 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. The balance sheet is clearly the area to focus on when you are analysing debt. However, not all investment risk resides within the balance sheet - far from it. We've identified 2 warning signs with EDP - Energias de Portugal (at least 1 which is significant) , and understanding them should be part of your investment process.

At the end of the day, it's often better to focus on companies that are free from net debt. You can access our special list of such companies (all with a track record of profit growth). It's free.

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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.