These 4 Measures Indicate That EDP Renováveis (ELI:EDPR) Is Using Debt Extensively

Warren Buffett famously said, 'Volatility is far from synonymous with risk.' When we think about how risky a company is, we always like to look at its use of debt, since debt overload can lead to ruin. We note that EDP Renováveis, S.A. (ELI:EDPR) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

When Is Debt A Problem?

Debt assists a business until the business has trouble paying it off, either with new capital or with free cash flow. In the worst case scenario, a company can go bankrupt if it cannot pay its creditors. 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, debt can be an important tool in businesses, particularly capital heavy businesses. 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 Renováveis

How Much Debt Does EDP Renováveis Carry?

You can click the graphic below for the historical numbers, but it shows that as of June 2022 EDP Renováveis had €6.53b of debt, an increase on €4.61b, over one year. However, because it has a cash reserve of €1.12b, its net debt is less, at about €5.41b.

A Look At EDP Renováveis' Liabilities

According to the last reported balance sheet, EDP Renováveis had liabilities of €4.79b due within 12 months, and liabilities of €10.5b due beyond 12 months. Offsetting this, it had €1.12b in cash and €2.15b in receivables that were due within 12 months. So its liabilities total €12.0b more than the combination of its cash and short-term receivables.

While this might seem like a lot, it is not so bad since EDP Renováveis has a huge market capitalization of €20.5b, and so it could probably strengthen its balance sheet by raising capital if it needed to. But it's clear that we should definitely closely examine whether it can manage its debt without dilution.

We use two main ratios to inform us about debt levels relative to earnings. The first is net debt divided by earnings before interest, tax, depreciation, and amortization (EBITDA), while the second is how many times its earnings before interest and tax (EBIT) covers its interest expense (or its interest cover, for short). 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 Renováveis has a debt to EBITDA ratio of 4.4 and its EBIT covered its interest expense 3.5 times. This suggests that while the debt levels are significant, we'd stop short of calling them problematic. The good news is that EDP Renováveis grew its EBIT a smooth 73% over the last twelve months. Like the milk of human kindness that sort of growth increases resilience, making the company more capable of managing debt. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if EDP Renováveis 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 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 Renováveis 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

EDP Renováveis's conversion of EBIT to free cash flow and net debt to EBITDA definitely weigh on it, in our esteem. But the good news is it seems to be able to grow its EBIT with ease. When we consider all the factors discussed, it seems to us that EDP Renováveis is taking some risks with its use of debt. So while that leverage does boost returns on equity, we wouldn't really want to see it increase from here. 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. For example, we've discovered 2 warning signs for EDP Renováveis (1 shouldn't be ignored!) that you should be aware of before investing here.

If you're interested in investing in businesses that can grow profits without the burden of debt, then check out this free list of growing businesses that have net cash on the balance sheet.

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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.