We Think Societatea Energetica Electrica (BVB:EL) Can Stay On Top Of Its 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 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. We note that Societatea Energetica Electrica S.A. (BVB:EL) does have debt on its balance sheet. But the real question is whether this debt is making the company risky.

What Risk Does Debt Bring?

Debt is a tool to help businesses grow, but if a business is incapable of paying off its lenders, then it exists at their mercy. If things get really bad, the lenders can take control of the business. 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, 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. When we think about a company's use of debt, we first look at cash and debt together.

View our latest analysis for Societatea Energetica Electrica

What Is Societatea Energetica Electrica's Debt?

As you can see below, at the end of September 2020, Societatea Energetica Electrica had RON815.6m of debt, up from RON753.3m a year ago. Click the image for more detail. However, it does have RON524.2m in cash offsetting this, leading to net debt of about RON291.4m.

How Healthy Is Societatea Energetica Electrica's Balance Sheet?

We can see from the most recent balance sheet that Societatea Energetica Electrica had liabilities of RON1.02b falling due within a year, and liabilities of RON1.00b due beyond that. Offsetting these obligations, it had cash of RON524.2m as well as receivables valued at RON926.6m due within 12 months. So its liabilities outweigh the sum of its cash and (near-term) receivables by RON572.1m.

Of course, Societatea Energetica Electrica has a market capitalization of RON4.79b, so these liabilities are probably manageable. But there are sufficient liabilities that we would certainly recommend shareholders continue to monitor the balance sheet, going forward.

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).

Societatea Energetica Electrica's net debt is only 0.32 times its EBITDA. And its EBIT covers its interest expense a whopping 42.5 times over. So we're pretty relaxed about its super-conservative use of debt. Better yet, Societatea Energetica Electrica grew its EBIT by 530% last year, which is an impressive improvement. If maintained that growth will make the debt even more manageable in the years ahead. When analysing debt levels, the balance sheet is the obvious place to start. But ultimately the future profitability of the business will decide if Societatea Energetica Electrica 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 business needs free cash flow to pay off debt; accounting profits just don't cut it. So the logical step is to look at the proportion of that EBIT that is matched by actual free cash flow. Considering the last three years, Societatea Energetica Electrica actually recorded a cash outflow, overall. Debt is usually more expensive, and almost always more risky in the hands of a company with negative free cash flow. Shareholders ought to hope for an improvement.

Our View

Happily, Societatea Energetica Electrica's impressive interest cover implies it has the upper hand on its debt. But we must concede we find its conversion of EBIT to free cash flow has the opposite effect. We would also note that Electric Utilities industry companies like Societatea Energetica Electrica commonly do use debt without problems. Taking all this data into account, it seems to us that Societatea Energetica Electrica takes a pretty sensible approach to debt. That means they are taking on a bit more risk, in the hope of boosting shareholder returns. There's no doubt that we learn most about debt from the balance sheet. However, not all investment risk resides within the balance sheet - far from it. For instance, we've identified 1 warning sign for Societatea Energetica Electrica that you should be aware of.

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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